By Timour Chayipov
Dividend growth investing is one of the most popular strategies used by investors and when applied consistently over the long term it works well. The basic idea is for investors to buy shares of companies that have long histories of increasing dividends and hope that in 10 to15 years the dividend yields relative to invested capital will grow from perhaps 3 - 5 percent to a more comfortable 10 or 15 percent.
We can describe this strategy with a simple formula:
Y = D / IC
Where Y is the dividend yield on the original invested capital; D is the annual dividend per share which is a variable number that hopefully increases 5 to10 percent per year; and IC stands for invested capital which is a constant and equals the amount of the original investment.
I would like to introduce a strategy whereby, instead of waiting for dividends to increase to a comfortable level, we can change the denominator of the ratio on the right-hand side of the formula from a constant number to a variable number, reducing it 10 percent or more each year, until the denominator becomes zero. What is our dividend yield on zero capital invested? If your guess is infinite, then you are right. And as we reduce our invested capital on one investment (or several simultaneously) we can redeploy our money to expand our portfolio holdings to increase the overall yield even more.
This strategy assumes that you are buying stock in a company for the first time, but it can also be applied if you already own a stock at a price you are comfortable with and want to hold onto for retirement. To employ this strategy we must sell a long duration strangle against our established stock position. A strangle is a strategy in which we simultaneously sell a put option and a call option with different strike prices on each, but both with the same expiration (The call strike is above today's price level and the put strike is bellow today's price level).
The premium received from a strangle will reduce our invested capital by as much as 15 percent to 20 percent immediately and then we repeat the strategy in each following year to reduce IC again and again, but usually by smaller percentages as we will often "roll" a position into the future (this process will be explained in greater detail both below and in examples provided on recommended stocks). By selling both a call option and a put option we accept two obligations: to sell our shares if the price of the underlying stock rises to above our call strike price at expiration or to buy additional shares if the price falls below our put strike price at expiration. This will all become clearer when we look at a detailed example later in the article. We can only have one obligation at any given time because it is not possible that price of stock will be simultaneously above your call strike and bellow your put strike.
You shouldn't worry about these obligations because you always have three choices:
- We can close out these obligations at any time by buying back our short options (hopefully for less than the premiums for which we sold them).
- If either option is exercised we are either taking a profit or accumulating more shares at a price that is low relative to the price at the time we sold the option contracts.
- And the third choice (most likely) : you can postpone your obligations by buying back your short options for less than the original premiums collected and then sell another one with expirations further out and different strikes (usually with net additional premiums which will reduce your invested capital even more; this is called "rolling" your position).
Which one we choose depends on the stock price level, your opinion about the company's prospects or any number of other circumstances, including personal preferences and investment goals.
Let's look at an example of how it works over several years:
Let's assume that we are absolutely comfortable with owning Lockheed Martin (NYSE:LMT) at today's price (June18, 2012) $85.0 (this is not a recommendation; we are using this is for example purposes only).
So we buy 100 shares of LMT for $85 and sell two options:
One January 2014 Put option contract with a strike price of $75.00 with a premium of $7.50 per share.
- One January 2014 Call option contract with a strike price of $90.00 with a premium of $5.00 per share.
The total premium we collect is $12.50 per share ($1,250), so our cost basis (Invested Capital) will be $85 - $12.50 = $72.50 plus we accept these two obligations:
- Either to sell our 100 shares if in January 2014, LMT is trading above $90 (our profit would be $90.00-$72.50 = $17.50 per share, or $1,750 which equals 24 percent, plus dividends received during this period of time).
- Or to buy an additional 100 shares of LMT at a price of $75.00 (our Put option's Strike) moving our average price per share to ($72.50 + $75.00)/2 = $73.75. Notice that this price is still well below the original $85.00 price where we felt comfortable owning the stock at the beginning. Unless something has changed fundamentally about the company we should still be happy to own the stock at this reduced level.
But, of course, it is also possible that neither of our option contracts get executed so we just initiate another strangle position and further reduce our invested capital (or cost basis).
Let's look at a few different scenarios:
- Price of LMT at expiration is between $90.00 and $75.00 (our Call and Put strike prices) - both options will be expired worthless and we sell new ones expiring in January 2015 probably very similar strikes and get an additional $7.00 to $10.00 premium (the actual size of the premiums depend on the volatility of LMT at that time) and reduce our invested Capital for additional $7.00 to $10.00.
- Price of LMT at expiration is above the Call strike price; let's assume a price of $95.00.
Our Put option will expire worthless and we can sell a new one: January 2015 strike $80.00 at around $5.00.
We have 2 choices on what to do with the call option contract: if we think that the price of LMT is too high and will pull back we simply allow the option to be exercised and sell our shares at $90.00 to get a profit $90.00 - $72.50 = $17.50 plus received dividends (if we make this choice we won't sell a new put option and will probably just wait for LMT to pull back to a more comfortable level before reestablishing a position again).
Our second choice: if we think that $95.00 is fair price for LMT in January 2014, we can buy back our Call at a price of $5 (it will be in the money and cost 95-90=$5) and sell a new Call option with a January 2015 expiration, strike price of $100.00 and a premium of about $4.00.
So, what we end up with in this scenario can be explained like this: we have $10.00 unrealized profit from owning the stock (moved from $85 to $95 and received dividends, plus we got additional premium $5 by selling a new put option and Lost $1 from rolling the Call option (bought back for $5 and sold a new one for $4). In this scenario we reduced our invested Capital by another $4.00 and now it will be $72.50 - $4.00 = $67.50.
- Price of LMT below our Put's strike; let's assume it is at $70.00. Here we also have 2 choices:
First: if we think that $70.00 is a very good price we can allow the additional 100 shares of LMT to be put to us at $75.00 (the strike price of our put option), our average price as stated earlier will be ($72.50 + $75.00 )/2 = $73.75 for 200 shares of LMT and at price of $70 our unrealized loss will be just $3.75 per share (but don't forget that we received dividends during the holding period). In this case we would sell two new January 2015 calls and two new January 2014 puts at strikes of 75 and 60 to get premiums of approximately $10.00 for each strangle and reduce our invested Capital per share $73.75 - $10 = $63.75 and then just wait for another year.
Our second choice: the call option expires worthless and we sell a new January 2015 call option with a strike price of $75.00 for about $5.00.
We buy back our troubled Put option at $5.00 (it will be $5 in the money) and sell a new one to expire January 2015 with a strike price of 60 and a premium of about $6.00.
So, now what do we have: we still own 100 shares of LMT and have an unrealized loss of $2.50 per share (72.5 - 70 = 2.5), but received dividends to help offset. Plus, we got an additional premium from the new call of $5.00 and an additional $1.00 from rolling the put (we bought it back at $5 and sold a new one for $6) and reduced our invested Capital by additional $6 and now it is $72.50 - $6.00 = $66.50 per share.
A little more advice to help implement this strategy:
- The key of success is making the right choice of companies and at the right price; choose only companies which have long histories of increasing dividends, which have low Betas, and historically trade in a range not wider than 20% of the entry price (just look at a weekly chart to determine that the distance between the recent high and low is less than 20 percent).
- Establish the position when the price of the stock is approaching the lower level of the range.
- Try to establish a position when the volatility of the stock and/or the overall market are high relative to historical levels (options will be more expensive and you reduce your invested capital faster).
- If you plan to double your position by executing Put obligation, allocate only 50% of normal allocation at the beginning (scale in). You can use this money elsewhere on other positions until it is needed.
If you don't have the time to watch the markets for the best entry point simply follow our articles and we'll try our best to provide some good opportunities to initiate positions in the future. This strategy has worked for me for many years and I hope it will work for you.
Good investing to all!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.