I want to dive a little further into my first article and talk about the role of options in boosting returns.
For this example, let pretend we've invested $100,000 in the portfolio (it will make it easier to divide or multiply my calculation to apply for one's own investment resources). Splitting the 100K evenly across the 10 stocks -- assuming market prices as of November 26, 2013 -- we should have the following number of stocks per 10K. I've also included dividend yields.
|Ticker||Price per Share||Number of Shares||Dividend per Quarter||Yield per quarter||Annual Yield|
-- Table 1: Portfolio with Dividend Yield. --
Let's use a dividend-reinvestment-program or DRIP to add to my positions quarterly.
Additional Shares Per Position = [(Dividend x Number of Shares) / Share Price]
|Ticker||New Number of Shares Q1||New Number of Shares Q2||New Number of Shares Q3||New Number of Shares Q4|
-- Table 2: DRIP Adjustments per Quarter. --
Assuming no dividend growth for the year, the portfolio DRIP yield is 2.74%.
As I stated in my previous article, I plan on dollar-cost-averaging my investments quarterly (equal-weight additions quarterly). For the example, let's assume we invest $10,000 a quarter. So, we DCA $1000 per position per quarter.
Additional Shares Per Position Per Quarter = ($1000 / Share Price)
|Ticker||DCA Shares Q1|
-- Table 3: Dollar-cost-averaging additional shares per quarter for a $10,000 quarterly investment. --
So according to my plan, I'm willing to invest the number of shares in the table above per quarter at today's prices. For example, if I had an extra $10,000, I would take $1,000 and buy 42 shares of Intel . I'm willing to buy the shares at today's price, because I think they are a good value.
Unfortunately, I don't have an extra $10,000 at my disposal today. However, I plan to save that much in three months. Is there a way to make use of that "future money?"
This is where options come in...
With options, I can sell someone the right to sell me shares (or put the shares to me) at the price I'm willing to buy at a time I specify and boost my yield in the process. Note: Options are contracts to buy or sell underlying stocks in units of 100. If you're unfamiliar with options, start here...
Let's go back to our example:
I'm willing to invest a $1000 per position per quarter. If I sell cash-secured put options (that are in-the-money as of today) I can earn the following amount per quarter:
|Ticker||Put Option Value||Capital Backup||Return on Capital|
-- Table 4: Selling put contracts to boost return on capital. --
As long as the stock stays below the strike price, the stock is assigned to me at the strike price. If the stock surges ahead of the strike price, no one will sell the shares to me below market value. However, I'll get to pocket the option price. The risk is, if there's a catastrophic event and the stock tanks, I'm forced to buy it at the contract price. However, I already intended to buy the stock at today's price. Why not collect a premium on the price and effectively purchase the stock at a discount? It's like collecting rent on your time.
By selling in-the-money put options in this example, I'm collecting $1888 on $53,550 in capital. You can either have $53k set aside to secure the puts, or you can use a margin account to cover the puts (you're not charged an interest rate unless your account balance is actually below zero).
Of course margin requirements for large-cap stocks are usually less than 100%, so you can leverage more contracts - but remember each expiring in-the-money obligates you to buy 100 shares. That is more than what you planned to dollar-cost average into each quarter (see table 3).
Ideally, the contracts are assigned to you near the strike price. You can then turn around and sell the stock that you were not planning on buying that quarter. The table below shows how many shares per contract would have to be sold if the stock price remains the same.
|Ticker||# of shares to sell back|
-- Table 5: Assume all the contracts are assigned to you and the stock price didn't change. You subtract the number of shares in table 3 by 100 (the number in the contract assigned to you) to get the number of shares to sell after contract assignment. --
Please note that you could also sell-in-the-money covered calls to generate revenue. However, I intend to sell options quarterly - if I sold a call and my shares ended up getting called away from me for a profit - I'd take a short-term gains tax hit. Additionally, it would go against my philosophy of slowly adding to my positions. That said, if a portfolio was large enough that you could sell a few shares - you could setup long-term (greater than 365 day expiration date) strangle options (cash-secure put + covered-call) on your positions. I haven't done the math on that idea yet...
If you have the discipline to commit to today's prices on the stocks in your portfolio and you're also willing to give up gains above your contract price, then selling in-the-money put contracts might be a way for you to increase your annual income from your capital beyond the yield from dividends. Using my example above you can earn about $2000 extra per quarter than you would from dividends alone. This approximately adds up to an additional 8% per year on top of dividends. Results may fall short of your expectations if the market drops more than what you collect on option premiums, or if the market soars past your strike prices (it's unlikely that you will be correct with your option calls 100% of the time). You can also apply this strategy to riskier stocks like small-caps and momentum stocks. It's not my style, but you'll earn a much higher premium for the added volatility risk.