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Enhancing Dividend Growth Using Option Strategies

|About: AT&T Inc. (T)

Summary

Investors at or near retirement do not enjoy the luxury of time to compound dividend growth by reinvesting dividends.

Despite the lack of time, these investors have several opportunities to increase their dividend growth.

The strategic use of options on the underlying dividend paying stock can enhance dividend growth.

There are numerable articles written on dividend growth strategies using the compound effect of time and expected dividend growth forecasted by the company. The underlying thesis of these articles is that we can increase our effective yield on our investments twofold: (1) enjoying the actual dividend growth experienced by the company that increases our effective yield on investment over time and/or (2) using our dividends to increase our holdings by reinvesting in the stock and purchasing more stock for our portfolios. Obviously the second option involves not consuming our dividends and employing the compounding factor over time with its reinvestment. This is a wonderful strategy for those who have time and not relying upon their dividends for day to day living. However, there are many in or nearing retirement where time is not available. Fortunately, there are still strategies available to enhance future dividend cash flow while simultaneously enjoying the dividend cash flow?

The use of various stock option strategies may provide these solution. We will explore one basic concept in this article. I highly recommend that you read available material on option basics to get an understanding. As a disclaimer, I do not have any interest in any online service nor compensated by any. My comments are solely based on my own activities and experiences over the last fifteen years. Further, the discussion below is for illustration purposes only and not a recommendation.

In this article we will be discussing selling an option against stock positions we currently hold generating a premium that will be paid immediately to our account. Essentially, we will be selling someone the right to buy our stock from us sometime in the future and for that right he must pay us a premium ("fee") now. Since we own the stock this is called a covered call strategy. It is covered because I already own the stock and he will simply have to pay me for the stock. Uncovered or naked is when I don't have the stock to sell and must go in the market to acquire it. To utilize this strategy, I would have in my portfolio holdings in stock that I believe are stable with sustained dividend growth over the years. The Aristocrat Dividend Stocks are very good examples. This article will focus on AT&T (NYSE: T) which meets our purposes. Additionally, you must be able to buy and sell options on that stock. Not all stock has option capability.

This basis strategy involves selling someone the right to buy my stock from me on or before a fixed date in the future at a fixed price. For that person to have the right to buy my stock, he must pay me a premium in cash now. The premium is composed of two elements: intrinsic value and time value. Intrinsic value is the premium component calculated as the difference between the strike price of your option and the value of the underlying stock. For example, if you sold someone the right to buy your AT&T stock at $32 on or before Feb 20, 2015 when today's price is $33.54, the person would have to pay you at least $1.54 in premium. You could easily sell that stock for $33.54, so why would you sell it to him for $32 unless he gave you the difference. That is the intrinsic value of the option. If the option price is $34 with the stock price at $33.54, there is no intrinsic value since he would not pay you $34 when he could go in the market and buy it for $33.54. For a call option to have intrinsic value the strike price of the option must be below the current market price of the stock. Time value is the premium component that I call the "risk component" that you require the buyer to pay for that right to buy your stock in the future. In other words, if you sell the person the right to buy your stock at $34 on Feb 20, what do you want him to pay now for that right? That time value is basically a probability value that the stock price will be at that price at expiration. It is a complex calculation involving many factors such as time remaining before expiration, volatility of the underlying stock, market forces and other elements. As a rule, the closer the option price is to today's current value of the stock and the longer until the option expires the greater the premium the buyer will have to pay you. And vice versa, the farther away the strike price is and closer to expiration, the lower the time value of the premium.

Time value decreases over time and is faster the closer the expiration date is. This is call time decay. We want to take advantage of this. Time decay is at its greatest in the last 30 days of the options life before it expires. Time decay will eventually consume the entire time value of the premium paid to you so at expiration the time value equals zero or no value. That is what we want. We want only to sell call options with no intrinsic value and only time value. Take a look at this chart borrowed from Options Genius on the effect of time decay.

Therefore, we want only option strike prices above our current market price. So in the case of AT&T, the option strike price must be above $33.54. Strike prices are priced in various multiples, typically at one dollar intervals. So we would be looking at strike prices of $34, $35, $36 and so on. These are called out-of-money options ("OTM") meaning they have only time value and no intrinsic value.

The next question is then how long do we want to give this person the right to buy my stock from me. As stated, the time value decreases rapidly during the last 30 days of the options life. Therefore, for our interest, we would look at expiration dates about one month out. I prefer to look at monthly options rather than weekly options for simplicity sake only.

Our purpose of this discussion is not about selling our stock but rather how to increase our dividend growth on our holdings. Therefore, it is not our intention to sell our stock. Thus, we must choose a strike price that we feel the stock will not likely obtain over the next month. We simply want to collect the premium today, add it to our holdings and let it expire worthless in a month. I like to use basic charts for this purpose. I want to know where the stock is relative to its historic pattern. I want to know resistance levels and support levels. I want to read the news to see if there is anything that could make the stock move rapidly. I also like to look at the last three years. One other indicator that I find useful is the MACD which gives me a market sentiment indication by plotting various moving averages against each other. It provides guidance for bearish/ bullish sentiment. I am not looking at timing a stock. I just want a feel of what can reasonably be expected and how the market as a whole is looking at the stock at that moment.

For reference, I pulled up the chart of AT&T on Edgar Online for demonstration purposes. The news feeds are not indicating anything extraordinary so status quo appears to be expected. Looking the chart covering the last three years, relative stability is noted with the stock price fluctuating between $32 and $38. Note the red line which represents a reasonable line of resistance around $36. The stock price does not seem to want to go above that price and if it does, it does not stay there long. So unless there is some underlying fundamental reason, we can make a reasonable assumption that $36 is our top price for the foreseeable future. If we sold a call option to a buyer giving him the right to buy our stock from us at $36 over the next month, our assumption is that the option will expire worthless. Regardless of what happens the premium is ours to keep and use as we please. Interestingly, studies have shown that the odds are the option will expire worthless.

But looking at the chart, I noticed also that AT&T tends to have some seasonality to it. It tends to be stronger during the summer and weaker during the winter months. The arrows that mark the Jan-Feb timeframe of the last three years shows the stock price weaker during this period but growing in strength as the year progresses. A resistance line for this time frame appears closer to $35. A reasonable assumption would be that absent some external news, the stock probably will not be above $35 over the next 30 days. However, in the spring that we could definitely see stronger stock pricing.

In light of the charts and news information available, we are comfortable selling a call option at the $35 strike price. The next month expiration is Feb 20, 2015. So for our illustration, we would sell the Feb20 35C. Next month we might consider the $36 or even the $37 strike price. This is a prime reason not to sell options too far into the future. Nearby expiration options expire and decay faster giving us opportunities to adjust if the market dictates.

Looking at the option chain for pricing of the Feb 20 AT&T call options provide by NASDAQ, we find the bid price is $.22. An option contract represents 100 shares of the underlying stock. Therefore, the market price right now for someone to buy a call option giving them the right to buy AT&T at $35 on or before Feb 22 is $22.00 per 100 shares. We would sell him that right to buy those shares from us and he would have to pay us the $22 per 100 shares which is credited to our account immediately for us to use. If we had decided to be really conservative, we could have sold the Feb 20C at the $36 strike price for $.07 or $7 per 100 shares. Remember, this is collected premium for only one month. It may be repeatable each month of the year.

To put it all together to understand the effect of growing our dividends in our portfolio:

We have decided to purchase 1000 shares of AT&T at the going market price of $33.54 costing us $33,540.00. It is currently paying an annual dividend of $1.80 for a 5.37% yield on our investment. The annual dividend is $1,800.00.

I am going to sell 10 call contracts at a strike price of $35 with expiration of Feb 20, 2015. I would collect $220 immediately as a premium. If I had been conservative, I would sell the $36 strike collecting $70. My annualized return for the $35 strike price would be $2,640.00, under the assumption that I could get the same amount each month. If I simply kept the cash and added to my dividend, my yield would equal $4,440 for a 13.24% annualized return. If I had chosen the conservative position, my annualized cash flow would be $2,500.00 for a 7.45% return. If you wish to keep the cash to add to your monthly cash flow that is your decision.

However, my purpose is to grow my total dividend return. If I would to keep the dividend for my personal needs and reinvest the option premium collected, my portfolio size would continue to increasing my dividend payout each month. As with the scenario of younger investors that can simply reinvest their dividends, this strategy allows for both the use of the dividend and the growth of the portfolio simultaneously. Of course, this is not including the anticipated annual growth on the dividend forecasted by the company. Thus we have a more active role in the growth of our dividends rather than simply waiting on the company to grow organically.

The premium is available immediately and can be used to purchase additional shares. If I had chosen the $35 strike price, I would increase my holdings approximately 7.9% with a resultant 5.79% dividend yield against my initial investment rather than 5.37%. In five short years, my initial investment could yield over 10% while still enjoying the fruits of the dividend payouts. Dividend increases provided by the company simply add to the total yield. The conservation position of a $36 strike price yields a 2.1% growth accordingly.

Thus for those in retirement or nearing retirement where time is not on our side, use of the covered call strategy is an active method to increase dividend payouts. A realistic goal is to stay ahead of inflation.

RISKS-

As with any strategy there are always risks. Aside from typical market risk, time value of money risk and opportunity risk there are some that are inherent to this strategy. They are all manageable.

  1. Market price is above the option strike price at the expiration of the option. The risk here is loss of opportunity and not loss of cash. The person would have to pay you the strike price, for example $35 in this illustration. Since the AT&T stock was bought at $33.54, there is a net cash gain of $1.46 plus the premium of $.22 for a gain of $1.68. The risk is if the stock appreciates significantly. We would lose any potential gain above the $35 strike price. Since I am in this strategy for cash flow, I am not concerned too much. An exercised option just means I made some more profit which I can reposition or reenter, my choice.
  2. Market price goes down rapidly. If the market goes down, and you wish to sell the stock, you would also have to buy back your sold option otherwise you would be exposed to serious risk. This is called "closing the position". If the stock price is going down, the option price is going down probably faster. Therefore, you would be able to buy it back much cheaper. The cost to buy back may only be $.05 for example leaving a $.17 per share profit on the option in the above illustration as you were paid $.22 to begin with. The profit will help offset any losses in the stock price that may occur.
  3. Volatility - Volatility in the stock price is a large component of the premium value of the options. Depending on the stock volatility, the option prices will fluctuate each month. Therefore, it is not wise to expect a certain return each month. Some months the premium will be lower than expected because the stock volatility is low. Other months the premium collected may be higher. This is to be expected. There is another whole study in looking at the historical volatility of the underlying stock. We are not going to look at that for the purposes of this illustration to keep it simple.

This illustration is not intended to be a full course in using options. The intent is to open the concept of selling options against our stock portfolios to enhance our current cash flow or increase our dividend yield actively. As always, study and practice before engaging in any investment strategy until you are comfortable with it.

Disclosure: The author is long 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.