Despite numerous economic concerns the US stock markets have continued their seven year bull run. Yet shares of Microsoft (NASDAQ:MSFT) have absolutely smashed both the Nasdaq and S&P 500 over the past year, surging an impressive 28%.
Which leaves many dividend investors in a tough spot. With Microsoft having run up so much so quickly, it's understandable that current and prospective investors are nervous about the company's becoming overvalued, with the dividend having fallen so much in recent years. So let's look at two low-risk option strategies that income-hungry investors can use to potentially boost shares on Microsoft shares.
First things first: is Microsoft really overvalued?
The first step to safely utilizing options to generate income is to determine whether or not a company's share price is over- or undervalued, as well as how that fits into your own individual portfolio's needs.
For example, if Microsoft is indeed overvalued due to its strong rally, and your position is now larger than you're comfortable with, then selling covered calls is a great way to potentially lighten your position with very little downside risk.
Similarly, if the company is overvalued but you're comfortable maintaining your current position, then there is another, even lower-risk way to still generate income even if you think, as I do, that Microsoft has a very bright long-term dividend future.
|Yield||5 Year Average Yield||PE||Historical PE||P/Cash Flow||Historical P/CF||Average Historical Premium|
My favorite way of determining current share price valuation is to look at both a short-term, as well as long-term fair value estimate.
For the short-term estimate I like to compare the current yield, PE, and price/cash flow to their historical averages. As you can see, Microsoft is currently about 8.2% overvalued by this method, indicating a short-term fair-value price of $53.66.
However, because long-term, buy and hold, dividend growth investing has proven itself to be the best way for retail investors to build wealth over time, we also need to consider what Microsoft is worth given its likely growth over the next five years.
|Morningstar Fair Value Estimate||Current Share Price||Sell Price Estimate||Premium To Fair Value||Distance To Sell Price|
For this, my preferred method is to check Morningstar's (NASDAQ:MORN) fair value and recommended sell estimates. While you always need to be highly skeptical of Wall Street analyst price targets, because Morningstar uses a long-term, fundamentals-driven, two-stage discounted cash flow model based on conservative assumptions, I consider it the gold standard of long-term intrinsic value estimates.
In this case Morningstar thinks that Microsoft is actually trading at a 6.4% discount to its likely five-year intrinsic value. In addition, the company believes that over the short term Microsoft might be able to run up close to $85, at which point shares would be massively overvalued and worth potentially selling.
So, with these valuation estimates, what are the best strategies for Microsoft shareholders searching for extra income? Read on to find out how you can potentially quadruple the yield on Microsoft shares you already own.
Covered calls: best, low-risk method for those looking to lighten their positions
Selling, i.e. writing, covered calls is the lowest absolute risk method for boosting your yield on Microsoft shares. Essentially you are selling the right for the buyer of the option to purchase 100 of your shares per contract sold at a predetermined strike price, if the share price is at or above that price by the expiration date.
|Call Option||Premium/Share||Effecting Sell Price (NYSEMKT:ESP)||Extra Profit @ ESP||Premium Yield||Annuallized Premium Yield||Total Potential Income Yield|
|Sep 16 $59||$0.63||$59.63||2.7%||1.09%||9.4%||11.9%|
|Sep 16 $60||$0.34||$60.34||3.9%||0.59%||5.0%||7.5%|
|Sep 16 $61||$0.18||$61.18||5.4%||0.31%||2.6%||5.1%|
|Nov 16 $60||$1.31||$61.31||5.6%||2.26%||8.6%||11.1%|
|Nov $16 $62.5||$0.60||$63.10||8.7%||1.03%||3.9%||6.4%|
|Jan 17 $60||$1.88||$61.88||6.6%||3.24%||7.5%||10.0%|
|Jan 17 $62.5||$1.02||$63.52||9.4%||1.76%||4.0%||6.5%|
For example, if you sell a September 2016 $59 call, then you're potentially selling your shares at a fixed price of $59.63 if the share price is above $59 by September 23rd. Since that represents only an additional 2.7% capital gain from the current share price of $58.06, this strategy is best used by those who are already overweight Microsoft, and looking to lock in profits.
Since you're already considering trimming your position at the current price, there is very little downside to guaranteeing yourself this small boost in capital gains. On the other hand, if Microsoft trades sideways or down over the next few weeks, and ends up below $59/share, then the contract expires worthless and you keep the 1.09% option premium. While that may not sound impressive, on an annualized basis it comes to 9.4%.
Not only is that a stupendous return for a very low-risk income strategy, especially in this age of negative interest rates, but it also means a potential total income yield on your Microsoft shares of 11.9% -- 2.5% dividend yield + 9.4% option yield. That means that if Microsoft's shares have run up too far, too fast and fail to rise above $59 through the end of September, you can potentially boost your income yield by 376%.
But what about investors who bought shares of Microsoft more recently and are not necessarily looking to decrease their position size? Or investors who are extremely bullish on the company's long-term prospects and are worried that shares may continue to increase, potentially resulting in leaving a ton of profits on the table?
In that case, there is an even lower-risk option strategy you can use -- a strategy that both generates income, and allows you to minimize the potential opportunity cost, and thus regret, if Microsoft keeps storming higher in the coming months.
Bear call spread: hedging your bets while still boosting yield
|Bear Call Spread||Net Premium/Share||ESP||Extra Profit @ ESP||Premium Yield||Annualized Premium Yield||Potential Total Income Yield|
|Sep 16 $59/$60||$0.29||$59.29||2.1%||0.5%||4.2%||6.7%|
|Nov 16 $60/$62.5||$0.71||$60.71||4.6%||1.22%||4.6%||7.1%|
|Jan 17 $60/$62.5||$0.86||$60.86||4.8%||1.48%||3.4%||5.9%|
The way a bear-call spread works is that you write a covered call, but also buy a higher priced, i.e. more "out of the money," or OTM, contract to benefit from a potential strong short-term price.
For example, if you sell a November 2016 $60 call, and buy a November 2016 $62.5 call, then you still receive a net premium of $0.71 per share, or $71 per contract (minus commissions). This creates an effective sell price of $60.71, or an additional 4.6% gain over where Microsoft is currently trading.
This particular spread is yielding 4.6% on an annualized basis, and creates the potential for total income yield on your shares of 7.1%. That's a truly fantastic income return given the high-quality of Microsoft's balance sheet, and strong long-term growth potential thanks to its growing market share in enterprise cloud computing.
However, you'll notice that writing this spread results in a far smaller annualized option yield than the 8.6% you could get just selling a November $60 call. Why might you want to consider this hedged strategy if you're giving up 4% income? Because of what might happen if the market stays frothy, and Microsoft keeps climbing strongly.
Say you sold just a November $60 call and Microsoft breaks out to $85, a price at which Morningstar would advocate potentially trimming your holding size. In that case, your shares would be called away at an effective sale price of $61.31, and you would have left 38.6% in profits on the table.
Worse yet, you'd probably be worried that, even during the inevitable market correction that will happen at some point, perhaps Microsoft won't fall back down to $58. For example, from $85 even a 20% bear market would only take Microsoft to $68.
In other words, to participate in the long-term Microsoft dividend growth story, you'd potentially have to repurchase shares 17.2% higher than today's price.
Except that you insured against this kind of scenario by purchasing that $62.5 call.
|Bear Call Spread||Minimum Value of $62.5 Call @ $85/Share||Effective Buy Back Price||Max Potential Opportunity Cost|
|Sep 16 $59/$60||$25.29||$59.29||2.8%|
|Nov 16 $60/$62.5||$23.21||$60.71||6.4%|
|Jan 17 $60/$62.5||$23.36||$60.86||6.2%|
Assuming that you waited until the day of expiration, and so there was no time value left in the $62.5 call, your option would be worth $85-$62.5 or $22.5. However, don't forget the $0.71/share premium you got when you set up the spread; creating an effective value of $23.21.
At which point you can buy 100 shares of Microsoft at the market price, while selling your call option, and creating an effective cost basis of $85-$23.21, or $61.79. That reduces your potential opportunity cost for generating the extra option income from 38.6%, (the potential capital gain you missed out on), to just 6.4%.
Of course you may also be only mildly bullish on Microsoft and think that $85 shares are just plain crazy. In that case you can always choose to sell your $62.5 call and simply accept an effective selling price of $60 + $23.21 = $83.21. This allows you to walk away with an extra profit of 43.3% compared to simply selling today. And since options are so wonderfully flexible, you can mix and match these above strategies.
For example,, you may want to roll up your call spread. This means, selling your $62.5 call and using the money to fund the majority of the cost of setting up a new spread, one that still generates a net premium, say at $86/$88.
Now, since this contract will be more in the money, you'll have to pay a premium to close out the $60 call. However, since you can also simultaneously sell a higher-priced, slightly out of the money call, say at $86, this may be able to still generate a net premium from the combined $62.5 call you sold, and the $86 call you now write in late November. Of course, since you're rolling the entire spread, you'll also need to purchase a higher strike-price call, to keep your hedge in place.
Why would you want to do this? Well it means that you avoid having your shares called away, which helps avoid capital gains taxes. More importantly, if Microsoft keeps charging higher, you can generate small incremental income while holding onto your shares, collecting the growing dividends, and thus maximizing your total income yield.
Details to keep in mind
While these two covered call strategies allow you to generate additional income on shares you already own, and thus represent less risk than, say, writing puts or bull put spreads on undervalued dividend stocks such as Apple (NASDAQ:AAPL), nonetheless there are a few things you need to consider.
First, while I ignored trading costs in the above tables, in reality you always need to keep in mind that commissions will eat into your option premium. The extent of that will be based on how many contracts you sell, as well as what broker you use.
For example, Interactive Brokers (NASDAQ:IBKR) charges $0.70 per contract with a $1 minimum commission. Meanwhile eOptions offers options trading for $3 + $0.15/contract, while other brokers, such as Options Xpress, charge a flat fee of $12.95 for up to 10 contracts, ($1.25 per additional contract beyond 10).
If you choose to write covered calls, make sure that your commission costs represent a reasonable, percentage of the income you're generating. A good rule of thumb for both options, as well as stocks, is to keep commissions to less than 1-2% of the value of your premium, or invested capital, respectively.
You also can't forget about taxes, because the IRS is going to demand a cut of your option premiums. All option-writing strategies are taxed as short-term capital gains, meaning at your marginal income tax rate. Also you need to remember that any shares that get called away will trigger taxable capital gains as well, though these are taxed at 0%, 15% or 20% depending on your tax bracket.
This means that covered call writing is ideally suited for tax-sheltered accounts, such as Roth IRAs. That is why you'll want to confirm with your broker whether your IRA allows covered-call selling, or if it requires additional paperwork before you can use this strategy.
Bottom line: Covered-call writing is a great, low-risk, highly flexible way to boost income on Microsoft shares no matter which way shares move in the short-term
Don't get me wrong, I'm not saying that options are for every investor. If you just want to keep things as simple as possible, then a long-term, buy-and-hold-and-reinvest-the-dividends approach with Microsoft is still likely to generate substantial future income, and market-crushing total returns, in the years to come.
However, if covered-call writing sounds interesting to you, then I highly recommend you research this low-risk, income-generating strategy further, and consider adding it to your arsenal of long-term income investing tools.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.