Restructuring My Dividend Portfolio, Part 1: Using Options To Boost Income Flow

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Includes: AAPL, CVX, DLR, GE, GIS, JNJ, KMI, KO, MO, ROST, T, WFC
by: Ong Kang Wei

Summary

This is the first article of a two-part instalment about the restructuring of my dividend portfolio.

In this article, I describe how I have decided to keep a permanent base of cash in my portfolio to take advantage of investment opportunities.

But opportunities do not arise frequently, and while I wait for opportunities, I will put the cash to work by using a low-risk options strategy to generate income.

This is part one of a two-part series regarding my latest portfolio restructuring operations.

For those who have read my previous dividend portfolio update, you would already know that I own a portfolio consisting purely of dividend-paying stocks. Although I still favor dividend investing, I am altering my portfolio to make it more personalized. These changes have been made with my past two years of investing in the markets in mind, while considering suggestions from Seeking Alpha contributors and commenters. I believe that this new portfolio structure will give me more flexibility and allow me to diversify some funds to take advantage of opportunities in other stocks outside of dividend stocks, such as growth stocks.

In short, this change will simply add three new segments to my portfolio, which are:

  • A base of cash to take advantage of attractive investment opportunities,
  • A portion of funds set aside for investments in growth stocks and other related opportunities that arise, and
  • A very small part of the funds for short term trades.

Although I will be adding three new segments to my portfolio, this article will address only one portion of my portfolio -- the base of cash, which will make up 25% of my restructured portfolio, and how I will be using options in this portion to make full use of this cash to boost my income stream. I will elaborate on the my dividend portfolio's new setup, and the two new segments in the second installment of this series.

Background

Cash is actually something I have in my portfolio all the times. This move to hold 25% of my portfolio in cash only makes it a permanent segment for me in my portfolio, as opposed to having no rule about the amount of cash in the portfolio. To me, this cash will be the base of my portfolio, protecting it from overall volatility, and allowing me to invest more funds into my dividend portfolio if any holding gets undervalued due to a correction in stock prices.

For example, both Digital Realty Trust (NYSE:DLR) and Kinder Morgan
(NYSE:KMI) experienced massive selling pressure late last year without
changes in fundamentals on baseless accusations from analysts and
hedge funds. Remember how Highfields valued DLR at $20 and when
other analysts also chimed in to make further bearish comments on the company? That would have been a good time to put the cash here to good use.

Using This Cash More Efficiently

Although this base of cash can and will be put to good use during a correction in stock prices, I realized that this cash will be idle during normal times, which is inefficient and carries opportunity costs. This is since this cash could have been invested in other stocks that would have produced returns. Hence, I am going to use the options strategy of selling puts to combat this issue.

For those who do not know about options, here is a short introduction to options:

Options are contracts that gives the buyer the right (but not the obligation) to buy or sell an underlying asset at a specific price on or before a certain date. There are two different kinds of options -- calls, which gives one the right to buy shares of a stated company at a certain strike price and date; and puts, which gives one the right to sell shares of a stated company at a certain strike price and date.

As you might already know, options can be used to amplify profits in short-term moves of a stock, since it offers a low cost method to take advantage of upswings (and downswings) in share prices. But buying options for such a purpose carry huge risks. Since options have a strike price and an expiration date, as opposed to normal shares, one wrong move can possibly cause an investor to lose his full investment. Hence, I do not recommend buying options in such a fashion unless one has experience in such an area.

Although buying options are undoubtedly very risky, selling options is much more risk-averse, and will even generate a steady flow of income for investors who know how to use it. In fact, the strategy that I am planning to use to generate income using this cash base is to sell at or out of the money, cash-covered short-term puts on fundamentally strong stocks that I am also interested in.

As mentioned above, buying puts allows one to sell shares at a given price on a given date, which is a form of insurance for one's stock positions. By selling puts, we become the insurance underwriter in a way, insuring a certain company's shares at a given price. This is since we commit to buy shares from the person who buys the put if the option expires below the given strike price. In exchange for providing the insurance, we will receive a premium, which is the also the aforementioned income that will be generated from this base of cash.

Although using this strategy leaves one exposed to the risk of being forced to buy the shares at the strike price when the option expires in the case that a stock falls significantly below the strike price, forcing one to lock in a loss on the shares straight away, there are ways to overcome this. One way that I will combat this is to only write options on world-class businesses that I do not mind buying at the given strike prices. In this case, I am able to simply collect premiums, month after month if the prices stay above the strike price. If prices fall below the strike price, I will just be buying fairly valued shares of a world-class company. This will be a good deal either way.

The Problem Of Overweighting Shares

This strategy is a great one to make use of idle cash, but there is one problem. If options keep getting exercised, and I keep buying shares, this cash base will eventually be used up. This will distort my portfolio structure and cause some dividend holdings to be seriously overweighted.

Hence, I will limit the number of options that will be exercised to a maximum of two contracts per year (given to relatively small size of my portfolio). This will be done by selling the options if there is a high possibility that the shares will be assigned to me at expiration, taking a small gain (which is possible at times, since options lose value as expiration nears) or a loss. I will then look at the technical situation then, and consider opening another trade to insure more shares of the same company at a lower strike price and a later date if the stock's technicals are favorable. If not, I will take the small gain or the loss, and move on to insure other high-quality companies when I see a good entry point.

In my opinion, this is a low-risk strategy that can be used to generate additional income for my portfolio using just a base of cash. This is especially since over 80% of options expire worthless, hence giving the option seller a significant advantage over the option buyer. This advantage is only heightened by the fact that I will only be "insuring" the shares of world-class businesses that I am willing to buy. I expect to use between 50% and 70% of my cash base selling such cash-covered puts most of the times.

My "Insurance" Watchlist

With a strategy in place, I will then need a list of stocks that I will continually insure. I do not want to continually find new stocks to insure, since it increases the chance of insuring a stock that I do not understand based on only impulse.

This watchlist will consist of high-quality stocks that I am willing to insure at the moment on a good entry point. The most important part of insuring stocks by selling puts is to ensure that they are world-class companies that I am willing to buy. Hence, after using screeners (to screen for value and quality), the Dividend CCCs list (Dividend Champions, Contenders and Challengers), and my own dividend portfolio, I picked 10 high-quality businesses trading at fair prices that I will be insuring when the opportunity arrives. Do note that I also considered option trading volume when I selected these names, and that I may change it, or add new stocks to the list when I decide to.

Company Price P/E Dividend Portfolio Component
Apple Inc. (NASDAQ:AAPL) $105.88 16.5 No
Coca-Cola (NYSE:KO) $42.53 23.6 Yes
Wells Fargo (NYSE:WFC) $51.64 12.6 No
Johnson & Johnson (NYSE:JNJ) $104.04 17.2 Yes
AT&T (NYSE:T) $33.80 10.4 Yes
General Mills (NYSE:GIS) $53.41 22.3 Yes
General Electric (NYSE:GE) $23.59 15.9 No
Chevron (NYSE:CVX) $105.12 9.7 Yes
Altria Group (NYSE:MO) $53.05 24.3 Yes
Ross Stores (NASDAQ:ROST) $91.14 21.9 No

After ensuring that these stocks are fundamentally top-tier businesses, I will then be relying predominantly on technical analysis to determine if I will insure the stock. I will be using historical price patterns, and also bollinger bands, moving averages, RSI figures and MACD indicators to determine support levels for stocks, so as to lower the probability of insuring a company whose shares are likely to decline on a technical basis.

Conclusion

In conclusion, this permanent base of cash in my portfolio will be used for two main purposes: the generation of income through conservative put-selling operations, and to purchase shares of companies when they are at attractive prices. This allows me to take full advantage of attractive investment entry points when they present themselves, while generating additional income for my portfolio along the way.

Stay tuned for more information on the my dividend portfolio, the new supplementary segments in the portfolio, and the full structure of my portfolio, which will be described in part 2 of this series. Meanwhile, you are invited to post any of your comments, opinions or questions in the comment box below.

Disclaimer: This is not a recommendation to use the options strategy mentioned above. Please research thoroughly, taking note of the risks associated with option trading before using it.

Disclosure: The author is long CVX, DLR, GIS, KMI, KO, MO, T.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.