By Mark Bern, CPA CFA and Timour Chayipov
How would you like to learn a strategy by which you can own a great company like Intel (INTC) that pays a rising dividend yield 3.6 percent and have the worst outcome be that you increase that yield by lowering your average cost per share? Now consider that in the event that the stock price rises you could reduce your invested capital by as much as 20 percent in the next 18 months. 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 upon 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 2 - 5 percent to a more comfortable 10 or 15 percent.
The objectives of this long-term, yield-enhancing strategy are:
- Buy and hold a quality company and collect the rising dividends long-term
- Systematically reduce the amount of your investment each year by 10 percent or more
- Reduce risk of loss to nearly zero unless the stock drops by more than 20 percent
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 INTC stock at the current price of $25.00 (all quotes are as of the market close on Tuesday, August 28, 2012). If you already own shares in INTC, 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 ($288) to reduce our invested capital as will be explained a little later in the article. We want to sell an INTC January 2014 put option contract with a strike price of $20.00 and a premium of $1.76. We will also sell an INTC January 2014 call option contract with a strike price of $30.00 and a premium of $1.12. In total we have collected a total of $288 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.).
Why did we choose the strike prices that we did? As we look at the 52-week high and low for INTC, we discover that the low is $19.16 and the high is $29.27. If we compare these prices to our options strike prices we find that the strike of $20 and $30 are very close to the recent low and high, respectively. Doesn't it make sense that if we really like the stock at the current level we might want to add more if the price drops to the 52-week low? Of course it does. This is called averaging down and is a very good strategy for building a long-term position in quality companies. It also makes sense that we have set the call strike price near the 52-week high in order to allow as much upside potential as possible. If the price rises close to the call strike price early we can roll the position to a higher strike price in the same expiration month using the premium collected from the new call option sold to buy back the existing call. That will allow us to preserve the upside potential without giving up the downside protection. To get a better understanding of the basics of options and of the concept of rolling a position please consider reading the two-part article we published titled, "Our Long-Term Investing for Increased Yield Strategy" Part 1 and Part 2.
So, what have we done? We bought 100 shares of INTC stock at $25.00 per share, but we also collected $2.88 per share in premiums. This effectively reduces our cost of the shares to $22.12 per share. Now, there are three probable 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? The yield rises each time the company increases the dividend and again each time you deploy this strategy, year after year.
In this first scenario, Intel's stock closes above our call strike price of $30. For example let's assume that the stock price is at $32 at expiration. We have two choices: either to let the stock be called away and accept our profit by selling at $30 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 (this is different from the rolling example mentioned above because here we are waiting for expiration while the other occurred earlier). In the first case (stock gets called away) we have a profit as follows:
- Realized gain on stock $500 ($3,000 - $2.500)
- Premiums collected $288
- Dividends collected $135 (probably below reality because it assumes no increases)
- Total $923; 20.5 percent return (including funds used to secure put)
Now, if we choose to roll the position, we can expect an outcome similar to this in-the-money call option for $2.00 ($32.00-$30.00) and sell another call option expiring in January 2015 with a strike of $37.00 for a premium of $1.00 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 $1.76 per share and we also collected the dividends over 18 months of about $1.35 per share. So far, after we combined these outcomes we have collected $2.11 per share. And now, as part of rolling the position forward we will also collect another put premium of about $1.50. In the end, we still own the stock and we have collected a total of about $3.61 per share in 18 months. That seems better than just sitting back and collecting the dividends of $1.35 to me. As a matter of fact it seems more than two and a half times as good.
- In scenario two we find that the price of Intel's stock has fallen below the $20.00 strike price of the put. For example purposes let's assume that the price has fallen to $18.75 (approximately 25 percent below the current price level and also below the 52-week low). 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 INTC stock at $20.00 per share. This would result in our owning 200 shares at an average price of $21.06 or ($22.12 + $20.00)/2. Our dividend yield on the 200 shares would be 4.3 percent assuming no dividend increases (not likely). If we like INTC at around $25 we really ought to like owning it at $21.06. Now we should tally up the total of what we have gained and lost thus far.
- Unrealized loss on INTC stock-$462 ($21.06 - $18.75) x 2
- Dividends collected $135
- Total Loss -$327
But now we will also sell two more calls and two more puts for January 2015 expiration and collect the premiums of about $250 for each strangle. Thus, we will have collected a total of $788 at this point, while collecting $135 of dividends on our invested capital that is now reduced to about $18.56 ($21.06 - $2.50).
But if we don't want to buy more INTC 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 $1.25 for the in-the-money call ($20 - $18.75). 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 $2.50 per share in new premiums. So, what do we have as a result? We still own the original 100 shares of INTC stock. We still have the premiums originally collected on the first strangle of $2.88 per share plus the $2.50 per share collected on the new strangle less the $1.25 paid to buy back the in-the-money put. We also have collected $1.35 per share in dividends. Add it all up and we have collected a net total of $3.18 per share. And we have reduced our invested capital by another $1.25 ($2.50 in new premiums - $1.25 paid to buy back put) to $20.87 per share. We are still collecting the dividend of at least $.90 per share which works out to a yield of 4.3 percent.
The most likely scenario is that INTC 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 $2.50 per share and reduce our invested capital to $19.66 per share. It is also possible (very likely) 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 invested capital 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 percent of the strike price multiplied by 100. While you will dramatically improve your return by needing to have less funds committed, you will also being accruing interest on the margined amount. But if you are investing through a tax-deferred account you will not be able to take advantage of this leverage. Your account will also be charged interest on the margin amount but this will reduce your return by less than the increase achieved by using the margin. On the other hand, the tax-deferred account does allow you to 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. The example provided in this article assumes no margin is used. Please consider which account type will work best to meet your goals.
For those of whom this scenario is entirely new, once again 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 an explanation of how this strategy can be applied to Procter & Gamble (PG), please consider this article. PG is one of those quality stocks that give us an opportunity only on rare occasions. If you own PG stock you may have missed this last opportunity, but a quick read of the article will prepare you for the next time. And there is always a next time with every stock.
As always, we welcome your questions and comments and will make every attempt to respond to all inquiries.