The Bottom Is In, But Dividend Investors Should Still Take Cover

|
Includes: AEO, DIA, DRI, NKE, QQQ, RAI, SBUX, SPY
by: Parsimony Investment Research

Summary

We believe that the bottom for stocks is in, but there will still likely be volatility ahead.

With the VIX above 20, now is a great time to utilize conservative option strategies to generate additional income.

Investors should consider a covered call strategy to help dampen portfolio volatility.

It's been a wild week! The Dow Jones Industrial Average (NYSEARCA:DIA) opened the week down almost 1,100 points and many investors felt as though the bottom was dropping out. Then stocks rallied back almost to even, but the markets succumbed to the selling pressure and the Dow finished the day down almost 600 points. On Tuesday, the Dow opened up over 400 points, only to give it all back and end the day down another 200 points. Fast forward to the close on Thursday... and it's like nothing even happened! All major stocks indices are now up on the week after huge rallies in Wednesday and Thursday's trading.

From peak to trough, the S&P 500 (NYSEARCA:SPY), Dow Industrials, and Nasdaq (NASDAQ:QQQ) were all officially in correction territory on Monday. Despite the rally over the past 2 days, though, we do think that investors should remain cautious as volatility will likely persist for at least the next 3-6 months. That said, we believe that the bottom that was put in on Monday morning will hold... but it could certainly be tested again before the markets march higher by year-end. As shown in the charts below, we predict that stocks will be range bound for the next few months -- with the 8/24/15 lows (red lines on chart) serving as the bottom of the range and some recent psychological levels for each respective index serving as the top of the range (green lines on chart).

Comparing Thursday's closing prices to the low end of the ranges means that there could be 6%-10% downside from current levels and 4%-8% upside.

Sell Options When Volatility Is High

Range bound markets are typically a great environment for selling options, especially when volatility has pushed option premiums higher. As shown in the chart above, the VIX closed at 26.10 on Thursday. Despite coming down from its high of 41 on Monday, when the VIX is above 20... it's a great time to sell options to take advantage of the juicy premiums!

We recently wrote an article highlighting a cash-secured put strategy that will help you generate income while putting a downside limit order in a stock that you would like to own. In general, we recommend selling covered calls into strength on stocks currently in your portfolio and selling cash-secured puts into weakness on stocks that you would like to own at a lower price.

This article highlights a covered call strategy that will also help dampen portfolio volatility (with a focus specifically around dividend stocks).

The Components of Total Return

The total return on a dividend stock has two main components: (1) the dividend yield and (2) the change in stock price. Most of the time both of these components have a positive effect on your total return. However, a significant price decline can literally "wipe out" years of dividends, resulting in a negative total return.

The price fluctuation in a dividend stock cannot be ignored. While dividends have accounted for over 40% of the total annual return of the S&P 500 since 1926, almost 100% of the returns over the past 10 years were attributed to dividends (meaning the return on the underlying stock was negative).

That said, dividend stock investors that would like to enhance the yield on their investments (to help offset the potentially negative fluctuations in stock price) should consider implementing a covered call strategy.

A covered call strategy will add a third component to the total return of a dividend stock and will increase the probability that the investment will have a positive total return over time.

Covered Call Basics

Source: Options Industry Council

The covered call is a strategy in which an investor writes a call option contract (for an equivalent number of shares) on a stock that the investor already owns. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership.

Though the covered call can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.

While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.

As expiration day for the call option nears, the investor considers three scenarios and then accordingly makes a decision. The written call contract will either be in-the-money, at-the-money or out-of-the-money. If the investor feels the call will expire in-the-money, he can hope to be assigned an exercise notice on the written contract and sell an equivalent number of shares at the call's strike price. Alternatively, the investor can choose to close out the written call with a closing purchase transaction, canceling his obligation to sell stock at the call's strike price, and retain ownership of the underlying shares. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock. If the investor feels the written call will expire out-of-the-money, no action is necessary. He can let the call option expire with no value and retain the entire premium received from its initial sale. If the written call expires exactly at-the-money, the investor should realize that assignment of an exercise notice on such a contract is possible, but should not be assumed.

Ideal Candidates for a Covered Call Strategy

In general, lower beta dividend stocks are ideal for option income strategies. Stocks with low betas will tend to be less volatile than the general market and should hold up relatively well in a range bound market. Since you are selling volatility with these strategies, you want actual volatility to remain low after you execute your strategy. Low beta stocks are less likely to surge (in either direction), making the probability of assignment lower.

For this analysis, we focused on the following stocks with a Parsimony Momentum Rating over 90 and a beta below 0.85:

  • Reynolds American (NYSE:RAI): Momentum (99) / Beta (0.54)
  • Starbucks Corp. (NASDAQ:SBUX): Momentum (98) / Beta (0.77)
  • Darden Restaurants (NYSE:DRI): Momentum (97) / Beta (0.55)
  • Nike, Inc. (NYSE:NKE): Momentum (94) / Beta (0.66)
  • American Eagle Outfitters (NYSE:AEO): Momentum (91) / Beta (0.84)

Choosing the Right Strike

There are three key components to look at when choosing a strike price for a covered call strategy:

  • Premium Yield (%) - The additional yield generated by the call premium (which is your downside protection from the current price). The more volatile the stock, the higher the premium (i.e., the higher the risk). An investor should typically target a 2.0%-4.0% premium yield for options with 2-4 month expirations.
  • Margin of Safety (%) - The margin of safety is the amount that the stock would have to drop from the current level (before expiration) to completely offset the call premium and the dividend yield. Note: If the underlying stock does not pay a dividend, the Margin of Safety will be equal to the Premium Yield. An investor should target a margin of safety of 3% or more (depending on the volatility of the stock).
  • Upside Profit (%) - The upside profit, which assumes that the option is assigned at expiration, is equal to the premium received + dividends received + the difference between strike price and current price. The more volatile the stock, the higher the expected upside profit. An investor should target at least a 5.0% upside profit potential for this strategy (which isn't bad for an 3 or 4-month return).

Note that investors could also consider writing an in-the-money call, which would maximize your premium yield but reduce your margin of safety. This should only be considered on stocks that you feel will be more volatile to the downside.

Generate Additional Income During a Market Downturn

Below are the specific call options that we would recommend selling on the candidates that we highlighted above. On average, the 2-3 month premium yield is 2.7%, with a margin of safety of 3.3% and upside potential of 8.5%.

Summary

Although the covered call strategy can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.

Disclosure: I am/we are long SBUX, RAI, SPY.

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.