The heading makes no sense whatsoever, right? How can a patient long term strategy like dividend-growth investing [DGI] work with what many see as "risky" options trading?. Since a lot of dividend and dividend-growth investors shy away from options, this article explains some basics that might seem trivial to more advanced option players. So let us get into the details.
Selling Puts: It's easy to get overwhelmed in the relatively complex world of options trading. Moreover, there are various permutations and combinations like strike price, expiration date etc. "Selling puts", however is one of the easiest to understand and implement. When you sell a put:
- You are taking a bullish position on the stock, contrary to the misconception that when you do anything with "puts" you are being bearish.
- You get a premium in your account right away for the obligation to buy the stock at the price you want on the date you want. So, you decide the date and the price you want to buy and they pay you for it. Simple isn't it.
- But you are taking a "risk" in that if the stock drops well below your strike price, you still have to buy the stock at the that price you chose and not at the open market price.
- You believe a stock will not drop below a certain level and if it does, you want to be a buyer.
Now, that last bullet point is where we believe merging dividend growth extrapolation and selling puts can be useful. Let us take the beaten down Intel (NASDAQ:INTC) as an example. This stock is slowly getting its due recognition as a dividend growth stock, though it's far from the leagues of Coca-Cola (NYSE:KO) and the likes.
Below is the January 2014 option chain for Intel as of this writing. The circled row is where we are interested in.
(Source: TD Ameritrade.com)
The Scenarios: The Jan 2014 $25 put is worth about $4.60. This means when you sell a single put contract (100 shares), you get paid $460 right away. And your bet is that Intel will not drop below $25 when the option expires in Jan 2014.
- If Intel is well above $25, your put expires worthless. You do not have to buy the shares through this contract but you earn 18%. ($460 earned for your willingness to put $2500 on the line). This 18% return by Jan 2014 will most likely beat your return in the same period if you buy the shares out right today, including dividends.
- If Intel is at or below $25, then you are obligated to buy the 100 shares you sold. So you pay $2500 and buy 100 shares of Intel. Though your statements at this point will show you have a $25 average cost on Intel shares, the fact is you got paid $450 already. So your "real" cost is much lesser.
- Right here is where dividend growth comes into play. If Intel continues to increase its dividend at the same rate as it has done over the past 5 years, the table below shows your expected yield on cost if you get assigned the shares when your put expires. In this example, we are talking about Jan 2014, so Intel's dividend will almost certainly be a $1/share by then. So you paid $20.4 per share ($25-$4.6) and your yield in 2014 will be close to 5%, which in all likelihood will be higher than the yield buying the shares outright in 2014.
(Source: Table created by the author with current dividend data from Finance.yahoo.com)
One more example: The chain highlighted below is for Coke's Jan 2014 expiration. Selling the $35 put today, for example gives you the chance to buy Coke at close to 4% based on its dividend growth history.
(Source: TD Ameritrade.com)
Conclusion: We love selling puts for stocks we want to buy at a certain price. If it's a dividend growth stock, you have one more factor to look at and evaluate your risk/reward - the dividend if and when you get assigned. Note, the table above is just one example at a single strike price. If you want lower premiums first up but are looking at a greater yield, you may have to look at a different strike price. In this example, $22 strike price will give you a higher yield but lower premium.
Disclosure: I am long INTC, KO. 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.
Additional disclosure: Long Intel shares as well as Jan 2014 puts.
Disclaimer:Please do note that if the stock goes well below the strike price, you will buy the position at a "loss" even though you will still get the dividends. That is why we believe strongly in using this strategy only for stocks that will increase dividends no matter what and hence have a likely bottom price. Evaluate your own risk tolerance level as well.