By Mark Bern, CPA and CFA, and Timour Chayipov
How would you like to learn a strategy by which you can own a great company like Procter & Gamble (PG) that pays a dividend yield of 3.8% and have the worst outcome be that you increase that yield by lowering your average cost per share? Now consider that in the other possible outcomes, you expect to earn a yield of at least 7% to 10%. This strategy is really for conservative investors who are looking for higher yield. It is not intended to be a quick path to riches. This is simply a derivative strategy based on dividend investing. The basic idea of dividend growth investing is for investors to buy shares of companies that have long histories of increasing dividends, and hope that in 10 to15 years the dividend yields relative to invested capital will grow from perhaps 3% to 5% to a more comfortable 10% or 15%.
This strategy simply expands on the same principal, but helps investors achieve a higher yield on their portfolios sooner by systematically reducing the amount of invested capital. We start to apply the strategy by purchasing 100 shares of PG stock at the current price of $59.98. If you already own shares in PG, this step is not necessary because we will simply show you how to increase the yield on what you already own.
Next we simultaneously sell a call option and a put option of the same expiration with long-term duration (both options with the same expiration but with different strikes) to maximize our premiums. This is called a strangle and it is really simpler than it may sound. We will use the premiums collected ($726) to reduce our invested capital as will be explained a little later in the article. We want to sell a PG January 2014 put option contract with a strike price of $55.00 and a premium of $4.75. We will also sell a PG January 2014 call option contract with a strike price of $65.00 and a premium of $2.51 (all prices and premiums are quoted as of the close on Wednesday, June 27, 2012). In total we have collected a total of $726 in premiums (we will not be including commissions in this series because they should be less than $10 per trade and vary significantly depending upon the broker, type and size of account, etc.).
So, what have we done? We bought 100 shares of PG stock at $59.98 per share, but we also collected $7.26 per share in premiums. This effectively reduces our cost of the shares to $52.72 per share. Now, there are three potential outcomes that we will explain in just a moment, but can you see how it is possible to reduce the original cost, not just this one time but as often as once a year until our invested capital becomes zero? That is the ultimate goal. And then what is the yield? Well, it rises each year until it becomes infinite, at least in theory. So, now let's take a look at the possible outcomes and our choices.
In this first scenario, PG's stock closes above our call strike price of $65. For example purposes let's assume that the stock price is at $68 at expiration. We have two choices: Either to let the stock be called away and accept our profit by selling at $65 per share or roll the position to a longer duration by buying back the call that is about to expire and selling another call that would expire in January 2015. In the first case (stock gets called away) we have a profit as follows:
- Realized gain on stock: $502 ($6,5000$$5,998)
- Premiums collected: $726
- Dividends collected: $342 (low because it assumes no increases)
- Total $1,589, 13.7%; 9.1% APR
Now, if we choose to roll the position, we can expect an outcome similar to this:buy back the in-the-money call option for $3.00 ($68.00-$65.00) and sell another call option expiring in January 2015 with a strike of $75 for a premium of $2.00 or more. We net a loss of $1.00 on this portion of the trade, but recall we still get to keep the premium from the put that expired worthless for a gain of $4.75 per share and we also collected the dividends over 19 months of about $3.42 per share. So far, after we combined these outcomes we have collected $7.17 per share. And now, as part of rolling the position forward we will also collect another put premium of about $3.00. In the end, we still own the stock and we have collected a total of $10.17 per share in 19 months. That seems better than just sitting back and collecting the dividends of $3.42 to me. As a matter of fact it seems almost three times as good.
In scenario two we find that the price of PG's stock has fallen below the $55.00 strike price of the put. For example purposes, let's assume that the price has fallen to $52.00. Again we have choices.
First, we could allow the put option contract to be exercised and we would be obligated to purchase 100 more shares of PG stock at $55.00 per share. This would result in our owning 200 shares at an average price of $53.86 or ($52.72 + $55.00)/2. Our dividend yield on the 200 shares would be 4.2% assuming no dividend increases (not likely). If we like PG at around $60 we really ought to like owning it at under $54.00. Now we should tally up the total of what we have gained and lost thus far.
- Unrealized loss on PG stock: $798 ($53.86 - $52.00) x 2
- Dividends collected: $342
Total Loss: -$456
But now we will also sell two more calls and two more puts for January 2015 expiration and collect the premiums of about $500 for each strangle. Thus, we will have collected a total of $1,272 at this point, while collecting 4.2% dividends on our cost basis that is now reduced to about $48.86 ($53.86-$5.00).
But if we don't want to buy more PG stock at a lower price we still have a choice. We can buy back the put and roll the position forward. This will result in our paying $3.00 for the in-the-money call ($55-$52). This is, of course, offset by the dividends collected and the premium from the call that expired worthless as well as the premium collected on the put we are now buying back. We will then sell another pair of options to expire in January 2015 (one put and one call) and collect about $5.00 per share in new premiums. So, what do we have as a result? We still own the original 100 shares of PG stock. We still have the premiums originally collected on the first strangle of $7.26 per share plus the $5.00 per share collected on the new strangle less the $3.00 paid to buy back the in-the-money put. We also have collected $3.42 per share in dividends. Add it all up and we have collected a net total of $12.68 per share. And we have reduced our invested capital by another $2.00 ($5.00 in new premiums-$3.00 paid to buy back put) to $50.72 per share. We are still collecting the dividend of at least $2.25 per share, which works out to a yield of 4.4%.
The most likely scenario is that PG stock remains within the range of the strike prices and both option contracts expire worthless. At this point we simply sell another strangle expiring in January 2015 for about $5.00 per share and reduce our invested capital to $47.72 per share. It is also possible to roll the position at any time that it becomes profitable to do so before expiration. The results are very similar to waiting for expiration. Of course we have also retained the stock and continue to collect the dividends that rise as our cost basis continually falls year after year.
The returns will vary depending on whether you are investing through a tax deferred account or a margin account. If you use a margin account then the amounts required to secure the put portion of the strangle could be as low as 30% of the strike price multiplied by 100. But if you are investing through a tax-deferred account you will not be able to take advantage of this leverage. On the other hand, the tax-deferred account does allow you to at the least defer any tax consequences on realized gains. If you are using a Roth account you will avoid the tax consequences entirely (assuming the laws do not change). There are benefits to using either account depending upon your individual situation. Please consider which account type will work best to meet your goals.
For those of whom this scenario is entirely new, we suggest that you refer to the original article that explains how the strategy works over several years with greater detail. We consider this strategy to be an extension of the dividend/growth, buy-and-hold investing strategy using options to increase the yield on your investments. For those seeking a focused analysis of PG and competitors in its industry, please consider this article.
Disclosure: I am long PG.