- Most investors have been trained to buy dips and generally that's a good strategy for the right businesses.
- We wait until one of the Dividend Champions dip and then sell an out of the money put.
- Selling puts on dips is a wonderful source of additional income.
- Selling the dips is also a great way to acquire high quality, dividend growing stocks at terrific prices.
That’s right; the Make Your Family Rich method for buying great stocks is to sell the dips, put options that is. To start with, the only stocks we buy are Dividend Champions (DCs). Well, almost the only stocks we buy. DCs are those stocks that have paid increasing dividends for 25 years or more. Many are the great American companies you know well like MCD, KO, PEP, MMM, JNJ, IBM, CAT, ED etc. You get the picture; a lot of big, well known companies. But they also include lesser known companies like Brady Corp (BRC which has paid increasing dividends for 35 years), Carlisle Companies (CSL, 44 years), National Fuel Gas (NFG, 50 years), Tootsie Roll Industries (TR, 52 years). How about Weyco Group Inc. (WEYS, 39 years)? Look, Weyco sells Florsheim shoes and I love my Florsheims. For 39 years Weyco has loved its investors.
Seeking Alpha is blessed to host Justin Law who maintains the list of DCs and updates his comprehensive data the first of every month. The data was originally the work of David Fish who passed in 2019. Justin has maintained the data since then. These two guys are Seeking Alpha treasures. Justin also maintains the data on Dividend Contenders which have increased dividends for 10 to 24 years and Dividend Challengers who have increased from 5 to 9 years. We use the Contenders and Challengers data too but more about that in a later article.
There are 142 companies on the Dividend Champion list at this writing. We maintain that list on Yahho Finance and during the trading day look to see how each is performing. Using the Yahoo Finance software we can order the 142 DCs on the basis of which are down the most. Then the magic starts. Let’s say one of the DCs is down to 90 at the time we check from 95 at the close of the prior day. That’s about a 5.6% decline which is uncommon among DCs. Should you buy that DC? Probably. But let me reframe the question in a MYFR way. Would you want that stock at $83? Well, you would want it more, right? Would you want it even more if I agreed to pay you $150 today to commit to buy 100 shares of that stock 60 days from now? I know our answer. You bet!
That’s the way an out of the money put works. You, the put option seller (sometimes called “writer”) are basically in the insurance business. Think about it this way. The person owning the stock has just seen a decline of 5.6% and he or she is likely unpleasantly surprised. The owner of that business may be reluctant to sell for a variety of reasons including not wanting to pay a large capital gain. But they also want to safeguard their investment in the event of another major decline so they buy insurance and you sell them that insurance when you sell a put option. You provide that insurance guaranteeing you will buy their stock if, in 60 days, it goes down to $83 or below. For that, you receive an insurance premium of $150. We love that insurance business as long as it is limited to DCs. The reason for that is we believe markets periodically act based on emotion. But with DC’s they tend to have a safety net of consistently increasing dividends and in time the price will come back.
Let’s look at some arithematic on our hypothetical put sale. We received $150 for guaranteeing to buy the stock at $83 should it be at that point or below 60 days from now. Let’s assume we sell a cash backed put. That means we have set aside enough money ($8,300) to buy the stock if necessary in two months. That means we receive about a 10.84% return on the $8,300 we set aside. Because the return is for two months we annualize the return in the computation: $150/$8300 x 6 = 10.84%. Not bad. If we do buy the stock at $83 then the effective cost to the put seller is $81.50. That’s the $83 minus the $1.50 put premium. In effect, you are not losing anything on the trade unless you have to buy the stock at $83 when the price of the stock at expiration is below $81.50. Remember, you liked the purchase when the stock dropped to $90.
We find that once a stock is a DC it tends to remain a DC. DCs are really sticky that way. During the pandemic market collapse we did have a couple of stocks cease to pay or reduce their dividend. Of the 140 or so DCs in early 2020 only two lost their DC status. We owned both of those and immediately sold the stock. Actually, we sold call options until the stock was eventually called away. Except for those two we own all the stock we owned back in February and March 2020. In addition, during the big dip in the spring of 2020 a number of our puts were exercised and we bought more DCs. With the huge subsequent recovery that worked out great. But what may be more important, our income continued to increase from month to month regardless of the market’s performance. In the MYFR method of keeping score on our portfolio’s performance we consider income as the most important measure (see my article “A Different Way to Keep Score of Your Investment Performance” in my Seeking Alpha blog). Markets go up and market’s go down. The individual investor controls none of that. But an investor can pick the businesses to own and by focusing on DCs he or she can control their income.
Dealing with options does take a little vocabularly adjustment. You don’t buy the dips you sell the dips. You don’t buy the stock; you sell puts. An “out of the money” put is one where the strike or exercise price in below the current market price. An “in the money” put is one where the strike price is higher than the current market.
I frequently encounter folks who understand the advantages and the math of options but have never traded an option. It looks complex mostly because it feels different from trading stock. Not to worry. You are not alone and just prceed slowly. By the way, the only way we use options is to sell puts. Ocassionally, we sell a call when a DC stops being a DC. We never buy options. Options are a lot less complicated if you limit youself to selling puts and the occasional call.
Patrick J. Keogh is the author of Make Your Family Rich; Why to Replace Retirement Planning with Succession Planning. He has a new book targeted at teen investors scheduled for publication in early summer, 2021. The working title is Hey Kid, Want to Own Great American Businesses? You can check out his web page and order the books on www.makeyourfamilyrich.com.
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