Don't Fear The Options - A Dividend Investor's Perspective

by: September on the Henry's Fork

Summary

This article was inspired by another Seeking Alpha contributor, RoseNose, and is meant to be viewed as a further introduction to options, specifically covered calls.

I use options, mostly covered calls, to provide income from dividend stocks and reduce risk.

I'd like to go through an example of covered call writing, especially what happens after you've written that first one.

Because of what I learned after the first cycle or two of covered call writing, I expanded my options use to spreads and other strategies.

There's way more to covered call management than I can cover here, so this is not exhaustive.  And that doesn't count the many other options possibilities.

Contributor RoseNose's most recent article, Covered Options Review For The Rose 88 Stock Portfolio And How To Do It Yourself, parallels some of my own experience with options, specifically covered calls. I've written a couple of articles for Seeking Alpha about my own journey into options and feel we overlap each other a bit, so I thought I'd use her article for inspiration and see if my own experience resonates with anyone in the SA community.

Rose is a very popular writer on Seeking Alpha, and I always enjoy her portfolio updates. On a personal note, one thing I really appreciate is the effort she makes to personally respond to nearly every comment. Commenters often put a lot of thought into their response, and a good comment stream can be worth as much or more than the article.

And Rose usually gets lot of comments. A little over a year ago, SA published a RoseNose article titled, How I Tiptoed Into Options For My 88 Stock Portfolio Plan And How To Make A Pfizer Put. To date that article has over 750 comments, so it's fair to say options are something people are interested in.

When I saw Rose's first options article I thought this seemed like a big departure for someone I thought was a strictly dividend growth investor, and I was very interested in her exploratory foray. I was not disappointed.

I was not then and am not now an expert in options, yet I use them almost every day. I think they're a useful tool to increase portfolio income and reduce cost and risk. I don't think you need to be a Formula 1 racer to drive a car, and I don't think you need to be an options expert to use options. The key in both cases is to have some specific goals and know your limitations.

Aren't Options Risky?

I was recently in Las Vegas to watch my all time favorite college football team, the Oregon Ducks, play my second all time favorite college football team, the Boise State Broncos in the Las Vegas Bowl.

To get to the game from my son's home in Summerlin, we drove within sight of the Strip. It's not like you could miss it. To anyone who's been to the Strip I ask, "are all those casinos there because gambling is risky"?

I contend the answer is "it depends". We all know there are two sides to the gambling equation in Vegas: "gamblers", otherwise known as "losers", and the "house", otherwise known as "winners". What separates the two is statistics. The house has statistics on their side so over the long run there's little risk to the casinos. Gamblers, on the other hand, do not have statistics on their side and have to beat the odds to come home a winner.

People think options are risky. But look at it this way. You can blow all your money in the stock market doing nothing more than going long stock. Just find the riskiest penny stocks you can find and you can turn a large portfolio into a small one pretty quickly.

So it is with options. Properly executed, options increase your odds of winning and decrease your odds of losing. You can assume a lot of risk or use options to reduce risk. I think options are as risky as you want them to be. My advice: Don't fear the options.

All our times have come
Here but now they're gone
Seasons don't fear the options
Nor do the wind, the sun or the rain, we can be like they are

Come on baby, don't fear the options
Baby take my hand, don't fear the options
We'll be able to fly, don't fear the options
Baby I'm your man

Don't Fear the Reaper, Blue Oyster Cult, 1976, with minor edits

Are you going to lose sometimes? Are you going to write a covered call that gets called out while the underlying zooms higher? Are you going to write a covered put that gets put to you for $50 while the underlying stock is trading at $42?

Probably so. But have you ever lost money on a stock? Did that make you give up on the stock market? You're reading this, so probably not.

Am I an options expert? I'm as close to being an options expert as I am to being a Formula 1 driver. Nevertheless I drive everyday and seem to do fine, and I write options, make money and feel pretty good about it.

Options provide incredible flexibility that allows you to respond to some degree in almost any circumstance. Just keep in mind there are more ways to use options than you'll ever figure out by yourself or I can address in this article. So I suggest start slowly, set modest goals while you learn your trade, then expand options use (or not) as you gain more education and experience.

Getting an Education

I've used options for several years, but only wrote covered calls, and then only rarely. I did fine but I never felt like I knew enough to use options intelligently. Even though I made money writing covered calls, I kept waiting for what I didn't know to bite me.

Not only that, but as a small investor the commissions were significant enough that I sometimes felt I was working for the broker. I had a couple of trades where the broker made more than I did.

So about a year and a half ago, I started a serious self-educational effort to see if I could learn enough to feel comfortable incorporating options into my investment portfolio. Commission costs have come down and I found a very low cost broker that makes commissions bearable.

As an aside, I recently got an email from an online brokerage firm. They asked if I wanted to get on a waitlist for fee and commission free option trading. My buddy Keven's motto is "if it's free it's for me". If it works for him it works for me so I'm waiting for my invitation to sign up and see what I think of the platform.

Where do you go when you want to learn just about anything? The internet, of course. I'd start with the Options Industry Council website. It has an entire education program that starts with the assumption you know nothing.

And you can also go to YouTube. Just go there, type in "covered call", and you'll get more information than you can watch. After a while you'll figure out who makes the most sense for your particular situation and you can start to focus on a few sources.

And that's just for covered calls. There are poor man's covered calls, covered puts, spreads, strangles, straddles, iron condors, butterflies, calendars, customs, and many, many more options strategies.

Initial Goal Setting

So as a dividend investor who wanted to use options for additional income, I set the following goals for my investment portfolio.

  • Between dividends and options premiums, I wanted cash flow of 10% annually on each position.
  • My portfolio would consist of large cap, dividend paying stocks. Think Verizon (VZ), Exxon Mobil (XOM), Coca Cola (KO), Dominion Resources (D), AIG (AIG), General Electric (GE), etc.
  • The dividend on each position needed to be 3% or higher, with the odd exception.
  • I'd only write covered calls until I had some experience, gained comfort in the process and understood how I could use (or not use) other options strategies. If I decided all I wanted to use was covered calls, that was fine with me.

Initial Position Execution

Now that I had a plan, I created a spreadsheet tool to help me decide whether the options premium I selected would, when combined with the dividend, give me the 10% cash flow I want on that position for that time period. Here's what it looks like:


(Source: Author)

In this example you can see I purchased 200 shares of AIG on 3/27/17 at $60.90. The yield is just over 2%, which contributes $256 of the $1,218 in cash flow I need to get to a 10% yield for the year. With its 2% yield, AIG is an "odd exception" mentioned above.

When I want to write a covered call, I plug the date in the "Expiration Date" field. This calculates the number of days from today until expiration, and calculates the options premium I need over this time period to achieve a 10% annual yield, based on the price paid for the underlying.

When I bought my AIG shares I wrote call options using a "buy/write". I bought the shares and at the same time wrote two covered calls with a May 5, 2017, expiration date. The calls were written for assignment at $61.50.

This seemed like a good deal to me. Not only did I collect $298 from the options premium, I stood to collect another $120 should I get called out by May 5. That was a great start and more than met my 10% annual return criteria for the option term.

I Wrote A Covered Call - So Now What?

So far so good. I bought some stock, wrote the calls, and waited.

Here's AIG's stock price starting on the 3/27/17 purchase date through December 22, 2017. Obviously AIG's price on May 5, 2017, was not above $61.50. So on May 1, I closed the position, and my stock became a free agent.

Chart

AIG

data by

YCharts

Let me digress here and point out that if all I'd done was buy AIG at $60.90, I'd have an unrealized loss right off the bat. The options premiums effectively reduced my cost to $59.41. I could have written another call at $60 and still come out at least even.

Instead, I rolled this position to June 2017, sold $62.50 calls, collected more premium, and added another dollar to the call price should the stock get assigned. I'll describe rolling in more detail below.

My point here isn't to go through my complete list of AIG transactions. My point is to illustrate that I had a goal of 10% cash flow from my dividend stock portfolio, and options help me achieve that in a flexible fashion.

So with 3 months left to go before the one year anniversary of my purchase, I've comfortably exceeded my 10% goal on AIG. That's good, because not every position will make that goal.

For example, I'm a bagholder holding some GE shares. When GE management cut the dividend, that put more pressure on the options side to make up the difference. I'm not there yet and I've lost huge value on the underlying stock. But I still think I can make 10% in cash flow on my original purchase price over a one year period.

On balance I'm happy with the results. On a total portfolio basis I've exceeded 10% cash flow from almost all my positions. That cash flow has helped offset some of the unrealized capital losses I have in GE, Gilead (GILD), AT&T (T) and a couple of others.

A Couple of Ways to Respond to Changing Underlying Stock Prices

There's lots of ways to respond if the underlying stock moves against you, either up or down, way more than I can cover here in any depth. I thought I'd address two ways, the roll and the spread.

The Roll

This is pretty simple. When you roll a call, you buy back the original call you sold and sell another one at a date further into the future. You can sell it at any strike price you want, but the example shown below assumes I'm rolling an AIG January call into February.

To do this, I'd pay $.39 per share to close the January $61 position and sell a February $62.50 call for $.53 per share, for a total per share credit of $.14, or $14 for 100 shares. In reality, as seen below, you're more likely to get closer to the midpoint of $.24, but the natural credit is $.14.

(Source: Author)

That might not seem like much, but you get three things:

  1. $14 in option premium, which you wouldn't get just by holding the stock. This is more than the dividend for the period, AND you're between dividend dates so you don't have to worry about getting called out of your stock by an upcoming dividend.
  2. The potential for an additional $150 in capital gains should you get called out at $62.50 instead of $61.
  3. An additional $14 in cost reduction. Let's say you make this trade and AIG stock drops to $59.31 like it did on 12/22/17. Depending on where you bought it in the first place, you could decide to sell it for a loss, which, when offset by the options premiums received, could turn the loss into a smaller gain or a scratch.

What do you give up? Upside. You have to decide if it's worth it to cap your upside and take the money or hold out for the possibility of even larger capital gains. That's an individual decision. Most of the time I take the money, because options also allow me to reenter positions using different strategies.

The Spread

On June 16, 2017, I executed a buy/write on Helmerich and Payne (HP).

Helmerich and Payne Buy/Write

(Source: Author)

After a couple of months, the stock took a wild ride down from around $58 to $42.50. During that period I rolled calls down to as low as $52.50. If called, I would have lost $2.50 per share in capital gains, but I'd already made more than that in call premiums. The stock kept going down and I decided that was it with rolling calls downhill. What to do?

Chart

HP

data by

YCharts

I changed strategies from covered calls to spreads. I used a combination of put spreads and call spreads to keep collecting premium while the stock was under my $55 purchase price. I also kept collecting dividends.

Spreads aren't what I'd call an advanced options strategy, but they do require a more advanced options trading approval, which the new investor may not get at first. Typically you start with Level 1, where all you can do is a covered call. After you get your feet wet with those, you can apply for higher trading levels.

I was going to provide a fairly detailed explanation of how spreads work. Then I considered that this article was a companion to Rose's and decided that was a bit too far. I'll just say that spreads are a great way to use options. They're a defined risk trade, which means that you know exactly the maximum amount you can earn and lose.

You do have to understand volatility, delta, theta and options pricing and sizing to use spreads. It's possible to win on 90% of your spread trades and still lose money. But again, if you get some education, exercise due diligence, and trade enough, it can be a successful strategy. So maybe some other time.

Conclusion

I believe I can significantly augment my portfolio income and never use anything other than covered calls. I may not get 10% cash flow on each position, especially in a falling market, but what I can get beats just getting a quarterly dividend.

Here's what I've found thus far:

1. I like covered calls on dividend paying stocks. They may be the least capital efficient form of options trading, but the combination of dividends and options premiums gives me peace and comfort.

2. I thought this process would be easy and mechanical. At first it wasn't as easy as I thought, strictly due to greed and fear.

When a stock's price rose, my call would increase in value, I would show a loss on the call position, and I would get closer to having my shares called away. I thought I'd lose my shares and miss out on a big upward move. Suddenly the price reduction I gained by selling the call plus the guaranteed profit lost some of its luster.

When the price fell, I'd see a gain on the call, but feared the underlying might drop below a price where I could write another call. Fear and greed oscillated back and forth as the stock rose or fell.

The best way for me to overcome these countervailing forces was to go back to my investment goals. I'm looking for cash flow in retirement first and foremost. Some of that cash is going to come from options premiums, some from dividends, and some from capital gains. As long as I get my 10% it makes it easier to ignore some of the movement.

3. Getting called out of stocks isn't as bad as I thought it would be. I got called out of KO after a few months and decided that was fine. In my opinion KO is overpriced, so it wasn't that hard to let it go.

4. There's plenty of fish in the ocean. KO was overpriced, so I put my money in other stocks I felt were less overpriced and wrote calls against those. I keep my eye on KO, and if it becomes more attractively priced I'll buy it again and write some more calls.

5. As I learned more about options I found out how to use other options strategies to mitigate the effects of rapidly rising or falling underlying prices. I now regularly use some of these, like spreads and iron condors.

6. I almost always sell premium. Only in the rarest circumstances do I go long options. I bought some way out of the money puts in GE when the company reorganization was announced, and I bought some way out of the money calls in Qualcomm (QCOM), since I believe Broadcom (AVGO) will have to increase its takeover bid.

Call it a quirk, especially in a low volatility environment, but there it is. I like to collect money up front, not lay it out.

7. It became very useful to acquire a better understanding of concepts like options pricing, return on capital and the Greeks. As this is a beginner's story, this part is beyond the scope of this article but is critical to understand if you decide you want to use options in a serious manner. If you apply for advanced options trading and don't know about delta, theta, volatility and a lot of other concepts you're in over your head. Don't do it. But learning these concepts is like learning anything else. It gets easier and more rewarding as you progress.

That's where I am so far. I've been trading options nearly every day since early this year. I like what I'm doing and it's met my income goals. I still consider myself a beginner, but now feel comfortable assessing and executing strategies beyond the covered call.

What do you think? I hope commenters who've expressed reservations in other articles may reconsider options as a tool in their investment toolbox.

Disclosure: I am/we are long AIG, D, GE, GILD, HP, QCOM, T, VZ, XOM.

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.

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