Do Naked Puts Trump Dividends For An Income Investor?

Includes: CVX, PG
by: Left Banker

A few days ago Aristofanis Papadatos published an article here (Selling Puts Of High-Dividend Stocks For Maximum Yield) describing an income strategy using naked put options on high-quality, dividend stocks as an alternative to owning them outright. His approach is to sell deep in-the-money puts with one-year strike dates on the same high-quality, dividend-paying stocks a more conventional dividend-income investor might choose to own. The article generated a fair amount of discussion and piqued my interest enough to take a closer look.

I chose two of his examples-Chevron (NYSE:CVX) and Procter & Gamble (NYSE:PG)-and looked at projected outcomes. He proposes selling deep in-the-money Jan 2015 put options on these stocks. His suggested strike prices are $140 for CVX and $95 for PG. On Friday, CVX's price was about $120 and PG's was $80.

For the following analysis I used midpoint prices for the put options on Friday, 17 January, and compared returns from a buy-hold-and-collect-dividends investment to returns from holding the short options for a one-year period over a range of projected prices. I included dividends using the current payouts plus a projected 5% increase, which is slightly conservative. PG increased its dividend by 7.0% last year and has a five-year average increase of 8.5%; the company is due for an increase with its next quarterly payment. CVX has had one-year dividend growth of 11.1% and a five-year rate of 9.0%. The normal time for the next increase would 2Q2014, so I expect one payment at the current rate and three at an increased rate. I did not include commissions (which could have a small difference in the favor of buying the stock outright depending on one's broker's fees for options contracts). Projected returns for the options come from

In plotting outcomes I took the results out to the strike prices suggested by Papadatos since returns on the short put options are maximal at and above their strike prices. I also added puts at lower strike prices for comparison.

Here are the results for one contract (puts) or 100 shares (purchase) of CVX and PG:

At the suggested deep in-the-money strikes there is a modest-some might say trivial-increase in profit at expiration: $19.95 per contract for PG and $75 for CVX for stock prices at expiration up to the strike price. At the somewhat less deep-in-the-money strike prices there is enhanced profit, but it becomes limited as price at expiration exceeds the strike price. The $140 and $95 strike prices suggested represent 14.3% and 18.75% gains for the year; I'll leave it to the reader to gauge how likely those gains may be for 2014. Papadatos premises his strategy on one selecting stocks that are deemed unlikely to see marked swings to either the up- or down-side.

There is, however, a complication that does not affect the original author, who is not in the US and does not benefit from reduced tax rate on qualified dividends. I'm unclear on how a foreign resident is taxed on US dividends, but Papadatos gives a 30% level in the comments. For US investors this can be an important consideration and can profoundly affect the results. Below I include charts using the same data as above expect this time I've determined profits after taxes using the 15% rate for dividend income (and long-term capital gains assuming the position is sold for capital gains income after one year), and 28%, selected as a mid-level rate, for ordinary income rates. Obviously, differences from the pretax situation will be somewhat lesser if you're on the lower side of 28%, or somewhat greater if your marginal rate is higher than 28%. As a guess, I'd expect income-oriented investors reading this would likely be in the 25, 28 or 30% marginal rate bracket.

Here a different picture emerges and the buy and hold strategy outperforms the options at the recommended deep-in-the-money strikes as long as the stock price shows an increase for the year. The option strategy is advantageous (lower losses) if the stock loses ground.

Clearly, this is a superficial analysis. Other factors come into play. Perhaps most importantly, the option strategy gives the investor money up front. Papadatos notes this in his article and points out that this allows some small leverage as the funds can be invested. A more complete analysis would have to account for the value of money for the year's time. Certainly this will offset a portion of the after-tax differences in returns.

Countering this advantage for the naked put strategy is the fact that owning the stock affords the investor the opportunity to sell covered calls, arguably a more profitable and potentially lower risk strategy than receiving the income at the beginning of the cycle from the short puts.

Perhaps the most disconcerting factor is the ever-present threat of having the stock assigned. Papadatos deals with this, but not very satisfactorily in my view. One can readily imagine adverse scenarios where the stock price declines and one is assigned the stock at a lofty price. Of course the investor who purchases the stock outright will experience comparable losses but these will not involve the immediate outlay of cash which many may find more palatable if only psychologically.

Clearly each of the alternatives has points for and against; there is no clear winner. It is also clear that one's individual tax situation will play a key role. But, from my point of view, a U.S. investor in all but the lowest tax bracket would likely fare better by buying the stocks, collecting the dividends and, if appropriate to her investment goals and plans, selling calls on the positions and selling for a long-term capital gain as those gains become attractive.

Disclosure: I am long CVX, . 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.