Dividend growth investors tend to have a long-term view on the market, seeking to accumulate shares of solid blue chip companies and watch their investments grow with the power of dividend reinvestment.
So for most such investors, "options trading" is the furthest strategy from their mind. Most investors view options as very risky bets, and it's no surprise, given the typical disclaimer:
Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.
But it turns out that some types of options aren't actually all that risky, and if used correctly, can help you get some extra returns out of your portfolio. This mini-series of articles will cover various options strategies that dividend growth investors can use to maximize returns without increasing risk.
Strategy 1: Cash-Secured Put Writing
I know that a lot of dividend growth investors are "value conscious." So rather than rushing all in with fresh capital, they prefer to wait until one of their wishlist stocks is "on sale," then buy it at a discount.
There are various ways to accomplish this. While some investors actively watch the market to determine entry points, others choose "automated" methods. One common automated method is to place a limit order so that your broker automatically buys the stock for you when it drops below a certain price - i.e., "if The Coca-Cola Company (NYSE:KO) is available at or below $72.50, buy 100 shares."
In this scenario, the investor has determined that they would be happy with purchasing Coca-Cola shares at $72.50 apiece. This is where put options come in.
A put option is a contract stating that on a certain date (the expiration date), the holder of the options has the right to sell 100 shares of a certain security at a certain price (the strike price). People usually buy put options when they believe the price of a stock is going to go down.
However, for there to be a buyer of a put option, there naturally has to be a seller - and that's where our dividend growth investor comes in. Say the investor wants to pick up shares of Coca-Cola, but thinks we'll see a pullback within the next few months. The investor would be happy buying Coca-Cola at $72.50. What the investor could then do is write ("sell to open") a $72.50 strike put option for Coca-Cola. According to the options chain, September-expiry $72.50 Coca-Cola puts currently trade for $0.65, meaning the options contract can be sold for a premium of $65. This $65 is credited to your account, and $7250 is then set aside by your broker in your account.
If Coca-Cola is trading at or below $72.50 on the expiry date, your $72.50 will then be used to purchase the Coca-Cola shares. Counting the 65-cent premium you received, your cost basis on these Coca-Cola shares is $71.85. If Coca-Cola is trading above $72.50, the option will expire worthless, and you get to keep your $65 premium for your trouble. This works out to a 0.86% return for the two-month holding period, or a 5.2% annualized return on the cash, which is a whole lot better than you're going to get for any money market fund. (No matter what, you get to keep the premium.)
The "risk" in writing put options is that if the value of the stock declines, you'll have a paper loss because you were forced to purchase at $72.50 when the stock might be trading lower. However, for the dividend growth investor, this is an immaterial risk because it's the exact same risk as going long the stock. Dividend growth investors don't care about paper losses, because they're looking at the purchase in the long term. If they would've happily bought the stock at $72.50, then there's no additional risk in writing the put option. In fact, there's slightly less risk, because the premium lowers cost basis.
The put writing strategy is useful when you want to acquire certain stocks at a certain price point. It enables you to essentially place a "limit order" on the stock while obtaining a premium, which will either serve as "income" or serve to lower the cost basis.
While options trading is typically seen as risky, I'd like to stress that put writing carries no additional risk above and beyond the risks associated with going long any stock. If you would happily purchase a given stock at a certain price, then you should be able to write a put option on the stock at that price. It's like agreeing to buy the stock at that price, with a little bonus thrown in. Any capital that you were planning to invest in stocks can thus be used for writing put options with no additional risk.
Two notes: first, I would recommend writing near-dated put options, i.e., those expiring in a 1-2 month timeframe. Without getting into the technicals, there are several reasons this generally provides the best risk/reward profile; it allows you to have your cash back fairly quickly, it maximizes time premium capture, and it allows you to react to changes and various opportunities in the market.
Second, say the value of the stock skyrockets. Using our example, say Coca-Cola hits 90 in August, making it extremely unlikely that it will dip to $72.50. In this case, the put option will lose money, which is great for you; like shorting a stock, you can "buy to close" the put option, which means you buy it back for current market value. Since you sold it for more than the current value, you get a tidy profit and can now reuse the cash to acquire stocks or write other put options.
Disclosure: I am long KO.