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Dividends and options strategy
Old 05-22-2005, 11:33 AM   #1
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Dividends and options strategy

Hi All!
I've been thinking about this for a while now. Has anyone used an options strategy with dividend paying stocks? There are two ways to approach this:

First, lets say that you are VERY interested in owning XYZ at a 4% yld, but the current yield is 3.6% and you think that is too pricey. You write (sell) uncovered puts for the number of shares you wish to buy at a strike price 10% or so below the current price. If the price drops below your strike price, you buy the stock (and keep the premium). If it doesn't you keep the premium for a nice percentage profit.

Second, after buying the stock, you write (sell) covered calls on the stock that are 10% or more out of the money. Ideally, the stock moves up slowly and closes below your strike price at expiration. If the stock stays below your strike price, you get the premium, which will increase your return by, 1-3% a year or so. If the stock rises above your strike price, then you have sold the stock at a 10% plus gain, received the premium and a dividend payment or two. (I'm looking a 3 to 6 months out on the options). If this happens, then you've got about a 15 to 16% gain or so in 6 months or less. That's enough for 4% withdrawals for the next 3 or 4 years (assuming the money was then put into an investment that covers inflation), and that should be plenty of time to find another opportunity or what for the stock to drop back down. Better yet, you then go back to the first strategy.

Of course, none of this can be done with mutual funds, so it's only for the stock pickers among us.

I welcome any experiences or thoughts on these strategies.

Beachbumz 8)
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Re: Dividends and options strategy
Old 05-22-2005, 11:53 AM   #2
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Re: Dividends and options strategy

I'd love for this strategy to work! This seems to be one of the few ways to make money in a prolonged sideways market. It'd work even better if that happens to be the sort of market we'll be in for the next 5-10 years.

What if you sell naked puts and the company announces a 50% dividend cut? The market would whack the price by at least 15%. You'd end up owning a contrarian deep-value asset with a dividend below 3%. Admittedly I can't even remember the last dividend cut from a large-cap stock.

What if you sold naked puts on GM in March (before it fell off the cliff)? As I see it, you'd buy the stock shortly afterward and watch it go on to achieve more double-digit losses. (Of course it'd have a great yield by then!) The strategy would have "worked" but not many would be able to look at a portfolio deep in the red and say to themselves "I'm gettin' a great dividend!"

I've read a couple books on options trading and I need to explore this concept, but I'm cautioned by a trader who says "I didn't understand options until I'd done a couple hundred trades, and after 500 trades I still have questions." I sure hope he's talking about the more esoteric strategies and not just writing covered calls...
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Re: Dividends and options strategy
Old 05-22-2005, 01:13 PM   #3
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Re: Dividends and options strategy

Quote:
Originally Posted by Nords
Admittedly I can't even remember the last dividend cut from a large-cap stock.
Ford, Delphi and Kodak cut their dividends in the recent past, didnt they? I could be wrong...just stuff I think I saw on bloomberg while scraping sleep off my face and feeding a baby.
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Re: Dividends and options strategy
Old 05-22-2005, 01:28 PM   #4
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Re: Dividends and options strategy

Quote:
Originally Posted by Beachbumz

I welcome any experiences or thoughts on these strategies.

Beachbumz 8)
Howdy Beachbumz. I've tried this approach a few times in the past several years. A few comments:

Realize that the option premium is composed of two parts:
-Risk free interest rate, combined with the time until expiration (curently low, but steadily rising, which really screwed up option premiums over the past 2 years)
-Implied volatility of the stock price (the more volatile the price is, the larger the premium.)

While it might sound like a great theory to sell a 45 put if the stock is at 50, if the stock does drop to 40 and you get exercised and buy it at 45, you won't get didley squat for a 45 call unless you go out 6-12 months. (and even then don't expect a huge premium) If that 45 put has a $2 premium while the stock's at 50, there's a reason it is that large.

Granted, you mentioned a stock that pays a dividend, and that is a good backup plan...but don't forget to include the dividend amount in your option calculations:

Ex: Stock trades at 50. Annual yield is 3% (1.50 dividend). If you write a 45 put that will cover two ex-dividend dates, you should subtract .75 from that put premium, since the stock will go ex-dividend and drop .75 for those two dividends, and put you that much closer to being exercised. Granted, in the long run, a well-run company will recover the amount of the ex-dividend with capital appreciation, but it will put you that much closer to exercisement in the short-term.

Also, I presume that you will be buying the stock on margin? If not, that means you have a hefty pile of cash just sitting there. Either way, you have to either incorporate margin loan expenses (currently about 5%), or the lost value of your cash just sitting there in a MM account earning 1.5% when it could be in a 5-year Pen Fed CD earning 5%.

So, you have to do an opportunity cost analysis of what else that money could be doing while it's either sitting idle, or to include your margin loan (note: Margin Loan interest IS tax deductible, offsetting your taxable dividend income, in many cases. Consult your tax advisor or the IRS website).

Having said all of that...I'll be brave enough to admit that I'm an option fool player that does follow that strategy.

However, rather than use your good idea of dividend plays, I prefer to write puts on stocks that have a metoric plunge in a single day due to 'bad-but-not-terrible' news.

For instance, a few months ago Sanderson Farms (SAFM) came out with earnings that missed slightly. The stock cratered from the mid 40s to the mid 30s. The volatility mushroomed due to the stock movement. I took the opportunity to buy the stock at 36.37 and wrote a covered 35 call (essentially, similar to writing a naked put) and picked up 5.10 in option premiums. My net cost in the stock was 31.27, and it was trading at 36. Sure, it was called away at 35 a few months later, but I just couldn't see the stock trading as low as 31....and even if it had dropped THAT low, I would simply repeat the process and sell another covered call. The only thing to worry about is if it drops A LOT more, and the only calls that offer any decent premium are too far below your cost to 'guarantee' you will make money if the stock gets called away.

Typically, the dividend paying stocks that pay any decent dividend aren't that volatile (beleagured car manufacturers excepted ), so I wouldn't expect MOST of them to offer fat option premiums (I'm sure there are exceptions).

Let me know if you come across any good dividend/option plays Beachbumz. My current plays are
WIRE (price: 11.30, cost with option premiums is 10.20, August 12 1/2 call currently written)
HDI (sold the November 42 1/2 put the day it was hammered down to 47 1/2), PKZ (OUCH....sold total of 6 August puts, average strike price of 37 1/2 with 4.80 in premiums...currently down at 26!!!)
ENDP (July 17 1/2 put for 1.15, stock is at 20.43)
UTSI (sold Jan 2006 12 1/2 put for 1.7, back when the stock was at 17 1/2. Now it's at 7 and some change....double ouch!)

Peter
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Re: Dividends and options strategy
Old 05-22-2005, 06:37 PM   #5
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Re: Dividends and options strategy

Hi Peter76!
Thanks for the well thought-out response. First of all, I've made hundreds of options trades (probably like you), so I understand the ins and outs (at least enough to be dangerous), but others may not. Secondly, like you, I have made and lost a lot of money writing uncovered puts in the past and I still do that today with my 'play money'. Fortunately, I have made a bit more than I've lost.* I do like your thought process for picking your trades. I made a lot of money on COF like that, but as you know, you can still get burned; for me it was CECO and IMCL.

This strategy, as you know, is quite a bit more conservative. I'm only talking about solid (relatively) high dividend paying companies with good track records. No GMs or Ford here. One could always get stuck with a MRK situation, but I think that's rare. In any case, the premise is that you WANT to own the stock at the lower price, so you would have bought it at the strike on the way down. You just wouldn't get the premium. Also, in practice, I'm only writing puts a month to 45 days out, so my example of 10% price drop was not fair (just trying to keep it simple). A more realistic example is 5% OOM. We are only talking premiums in the .50 to .80 range, so not going to make you rich. Again, it's just if you WANT to buy the stock, but at a somewhat lower price. I've recently done this on BAC, PGN, DUK, GAS, and ABS.

Your point regarding the funds is well taken. I don't use margin at all, and I don't recommend it. The funds are available to purchase the stock, in fact I WANT to purchase the stocks. My reserve funds for this are held at Interactive Brokers in 3 month bonds that are yielding 7.6% (only available to accredited investors and not insured), so the funds issue is not a problem for me, but it could be for others. BTW, my MM is yielding 2.5%.

The main part of the plan is in owning the stocks, paying an average of 4% and writing covered calls to pick up another 1-3% return. Then, as long as the appreciation or the dividend keeps pace with inflation, you can get the magical 4% withdrawal rate and more. If the stock doesn't keep up with inflation, then the premiums on the covered calls will help out.

There are definately pros and cons to this kind of strategy, but it seems pretty good to me.

Beachbumz* 8)

BTW, I think I'll start another thread re: options writing, since that's a bit OT*
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Re: Dividends and options strategy
Old 05-22-2005, 08:14 PM   #6
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Re: Dividends and options strategy

Quote:
Originally Posted by Beachbumz
Thanks for the well thought-out response.
Well, it's more of a stream-of-consciousness thing. Sometimes it makes sense, sometimes it doesn't. Chaos theory is a thing of beauty

Quote:
Originally Posted by Beachbumz
Also, in practice, I'm only writing puts a month to 45 days out, so my example of 10% price drop was not fair (just trying to keep it simple).
Not to be nosey , but about how many option contracts are you talking about? My broker charges $29 min per option trade (up to 10 contracts)...you can't get too much cheaper than that, so by the time you subtract commissions, you'll be needing at least 5 contracts for it to be worthwile...



Quote:
Originally Posted by Beachbumz

I don't use margin at all, and I don't recommend it. The funds are available to purchase the stock, in fact I WANT to purchase the stocks. My reserve funds for this are held at Interactive Brokers in 3 month bonds that are yielding 7.6% (only available to accredited investors and not insured), so the funds issue is not a problem for me, but it could be for others. BTW, my MM is yielding 2.5%.
Why...margin is what makes it....EXCITING!!!

Ummmm....those 7.6% 3 month bonds: are they anything like the securities offered by American Business Financial Services that declared bankruptcy a short while back? (you know, the firm that advertises those 10% 1-year notes in your local Sunday paper, and once you get on their mailing list, they send you 2 mailings PER WEEK). I don't know if I would be putting my 'reserve funds' for option calls in unsecred, junk, Z-class subordinated debentures....

Quote:
Originally Posted by Beachbumz

The main part of the plan is in owning the stocks, paying an average of 4% and writing covered calls to pick up another 1-3% return.

There are definately pros and cons to this kind of strategy, but it seems pretty good to me.
Sounds like an excellent strategy Beachbum. My only concern is that I've already loaded up a bunch of money into DRIPs (utilities, financials, REITS), and being the extremely conserative person I am (politcally, morally, fiscally, behaviorally), I tend to prefer most of my assets in higher yielding bonds/preferred stock, rather than REITS or equities yielding 2-4% less (I know, earnings and divvies grow over time...just give me a little time to come around and see the light).

So, my only problem would be having enough moolah allocated to keep buying common stocks if I time it completely wrong and keep getting my puts exercised.
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Re: Dividends and options strategy
Old 05-22-2005, 09:44 PM   #7
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Re: Dividends and options strategy

I swear, when I my I.Q. was tested as a kid, they put me at over 130 and stuck me in a gifted program. I seem to be smart, I enjoy reading, I excel at what I do, I swear. But this stuff leaves me bleading from the ears!

I have a co-worker who borrowed 100k from his fast appreciating San Diego house and does a furious amount of covered calls, puts and leaps. He has, over the last 2 years averaged 5% a month, and now has over 300k in his trading account. His DW says she wants him to pay off the loan now, but he figures that would be a foolish with the way things have been going. He subscibes to a newsletter -something about we are cows, not pigs-and wants me to join up. I am afwaid, vewy vewy afwaid....
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Re: Dividends and options strategy
Old 05-22-2005, 11:03 PM   #8
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Re: Dividends and options strategy

These results sound quite good. My only comment would be that you really won't know until you have gone through a full cycle what risks you are taking. Victor Niederhoffer was a option seller and make a lot of money almost every year.

Until he busted. Twice.

LeRoi
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Re: Dividends and options strategy
Old 05-23-2005, 09:36 AM   #9
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Re: Dividends and options strategy

Quote:
Originally Posted by Peter76
Not to be nosey , but about how many option contracts are you talking about? My broker charges $29 min per option trade (up to 10 contracts)...you can't get too much cheaper than that, so by the time you subtract commissions, you'll be needing at least 5 contracts for it to be worthwile...
Whew, get another broker!* OptionsXpress is 1.50 per contract, with a $14.95 minimum. Interactive Brokers is $1.00 per contract with NOOOOO minimum. That is one thing that makes this strategy viable. IB does have a $10 per month minimum commission. You will save big time there on your trades.

Quote:
Why...margin is what makes it....EXCITING!!!
It is exciting, but margin calls are not! I have no real problem with it, if you know what you are doing, but I've seen some people get hurt pretty bad. I just don't need it with how I trade.

Quote:
Ummmm....those 7.6% 3 month bonds: are they anything like the securities offered by American Business Financial Services that declared bankruptcy a short while back? (you know, the firm that advertises those 10% 1-year notes in your local Sunday paper, and once you get on their mailing list, they send you 2 mailings PER WEEK). I don't know if I would be putting my 'reserve funds' for option calls in unsecred, junk, Z-class subordinated debentures....
I hesitated to even mention this, because people are soooo skeptical and that's fine. I've seen those ads in the paper, I'll stay away from them! Interactive Brokers makes these bonds available to their customers who are 'accredited investors' To qualify, you have to have a NW of 1mil and annual income of 200K. (I'm not answering any questions about that** ) They are actually 15 month bonds, I assume for their financials, but they announce their intent and DO redeem them every 3 months. You can either cash them out or roll them over. They have done this for over 3 years now and redeemed them in 3 months every time, but I guess there is no guarantees. The coupon rate is 8%, but the commission of 1.00 per 1000, brings the yield down to 7.6%. A financial publication did an article and mentioned the bonds not too long ago (maybe Barron's), and now the 3 months are pretty maxed out, so they have issued some 18 month bonds, with a 6 month call at 8.0%.

Quote:
Sounds like an excellent strategy Beachbum. My only concern is that I've already loaded up a bunch of money into DRIPs (utilities, financials, REITS), and being the extremely conserative person I am (politcally, morally, fiscally, behaviorally), I tend to prefer most of my assets in higher yielding bonds/preferred stock, rather than REITS or equities yielding 2-4% less (I know, earnings and divvies grow over time...just give me a little time to come around and see the light).
The dividend stocks I've looked at all yield at least 3%, most 4% or higher. PGN is currently yielding 5.35%, with the stock at 44 and you can write a Jan '07 50 for .90, which would add another 1.2%+ per year paid in ADVANCE. This would give you a 6.5% withdrawal rate, assuming the dividends keep up with inflation! If the stock goes above 50 by expiration, then you've got a LTCG of over $6.00 per share, or another 8.5% annualized, that's about 15% per year with the dividends and option premium!

Quote:
So, my only problem would be having enough moolah allocated to keep buying common stocks if I time it completely wrong and keep getting my puts exercised.
That would be a problem* , you would have to decide to change your allocation I guess, if you wanted to follow this strategy.

Beacbbumz* 8)
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Re: Dividends and options strategy
Old 05-23-2005, 11:49 PM   #10
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Re: Dividends and options strategy

(quote from Laurence - I tried to quote his post, but the website said the system verification thingie went kaputz)

I swear, when I my I.Q. was tested as a kid, they put me at over 130 and stuck me in a gifted program. I seem to be smart, I enjoy reading, I excel at what I do, I swear. But this stuff leaves me bleading from the ears!

(end quote)

Don't sweat it Laurence. I may sound like I know what I'm doing, but from my results, it's obvious that I'm quite the incompetent investor. Better to acknoweldge and accept what you don't know, rather than charge blindly into the unknown, thinking you know what you don't.

Also, if you think I sound intelligent from my earlier post - just take a gander at my college transcript for Intro to Electrical Engineering (note: I dropped it the first time around), Statics, and Dynamics I (also dropped that one the first time around) and II. You'll be quite impressed at my ignorance. (hint: the average grade from the above four courses was a Delightful D)
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Re: Dividends and options strategy
Old 05-24-2005, 07:14 AM   #11
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Re: Dividends and options strategy



(end quote)

Don't sweat it Laurence. I may sound like I know what I'm doing, but from my results, it's obvious that I'm quite the incompetent investor. Better to acknoweldge and accept what you don't know, rather than charge blindly into the unknown, thinking you know what you don't.


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"there are known knowns, known unknowns, etc......" D. Rumsfeld

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Re: Dividends and options strategy
Old 05-24-2005, 10:50 AM   #12
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Re: Dividends and options strategy

Quote:
Originally Posted by Peter76
...just take a gander at my college transcript for Intro to Electrical Engineering,... Statics, and Dynamics I ...and II. You'll be quite impressed at my ignorance. (hint: the average grade from the above four courses was a Delightful D)
Anyone who takes those courses-- especially two semesters of Dynes?!?-- may not be very smart, but you've certainly learned a lot!

And I suspect that most of us will initially experience a similar performance with options trading, although eventually both educations will enable us to make a living at our chosen fields. The trick is to not go broke in the process.
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Re: Dividends and options strategy
Old 05-26-2005, 06:34 AM   #13
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Re: Dividends and options strategy

Quote:
Originally Posted by Beachbumz
Hi All!
I've been thinking about this for a while now. Has anyone used an options strategy with dividend paying stocks? There are two ways to approach this:

First, lets say that you are VERY interested in owning XYZ at a 4% yld, but the current yield is 3.6% and you think that is too pricey. You write (sell) uncovered puts for the number of shares you wish to buy at a strike price 10% or so below the current price. If the price drops below your strike price, you buy the stock (and keep the premium). If it doesn't you keep the premium for a nice percentage profit.

Second, after buying the stock, you write (sell) covered calls on the stock that are 10% or more out of the money. Ideally, the stock moves up slowly and closes below your strike price at expiration. If the stock stays below your strike price, you get the premium, which will increase your return by, 1-3% a year or so. If the stock rises above your strike price, then you have sold the stock at a 10% plus gain, received the premium and a dividend payment or two. (I'm looking a 3 to 6 months out on the options). If this happens, then you've got about a 15 to 16% gain or so in 6 months or less. That's enough for 4% withdrawals for the next 3 or 4 years (assuming the money was then put into an investment that covers inflation), and that should be plenty of time to find another opportunity or what for the stock to drop back down. Better yet, you then go back to the first strategy.

Of course, none of this can be done with mutual funds, so it's only for the stock pickers among us.

I welcome any experiences or thoughts on these strategies.

Beachbumz 8)
Hi Beach!

I think about covered put writing from time to time. There is a broker in the VA Tidewater area who has made a career out of exactly that. I though of opening an accout a couple of times but now that his minimum account is $250,000 - no way. But the concept is very enticing. You make money if the market is up or sideways. He recommends never optioning a stock you wouldnt want to own.

His example of the worst mistake he has made was having HD "put to his client" at a few dollars over market price. So we immediately started selling calls against the stock and eventually sold out at a profit. Then started all over again.

He claims his avg. client returns are above 10%. He says that that clients respond to profits and his track record is very good. Client list keeps growing.

He says 99+% of his activity is strictly writing covered puts.


I'm still interested.


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Re: Dividends and options strategy
Old 05-26-2005, 12:20 PM   #14
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Re: Dividends and options strategy

Hi Bum!
Wow, 250K that's pretty steep!
I agree that you should never write a put on a stock that you aren't willing to own. This is a mistake that I made back last year, that cost me dearly. Also, if there's bad news out there, like a pending law suit or something, stay away.

You can do this on your own with lower minimums. I do some covered put writing in my IRA with OptionsXpress and have had some success. My preference would be to do a modified version of the covered put writing. I would use Interactive Brokers for this because their commissions are the lowest I've found and the executions are good. You are only required to put up 25% of the stocks current value plus the premium less the amount out of money the strike price is. An example:

BAC at 46.50. 25%=11.63-1.50=10.13+whatever the premium is. The premium is kind of irrelevant since you are paid that up front. Anyway that's about 22% of the strike price.

So, based on this, you can leave maybe 30% of the stocks price in the account (to cover small fluctuations) and keep the remainder in a MMA that pays 3.25%, which is usually better than you will get at the broker. You are still 'covered'. A more aggressive approach would be only to keep a total of 50% available since you can buy the stock with margin. This approach increased the return and the risk, of course.

Another problem to consider is that a stock can drop several points below your strike price and you will not be able to write break-even calls on it. An real life scenario for me is IGT. The stock got put to me at 35. The stock is currently at 28.56. A July 35 call is worthless. This is the major problem I see with completely covered calls. You have to get very close to the strike to make a decent return. If you are willing to take the risk of a little leverage, then you can write a put that is further out of the money and still get a great return. The risk is still there, that you will have to buy it, but it would be at a lower price.

Beachbumz 8)
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Re: Dividends and options strategy
Old 05-26-2005, 12:52 PM   #15
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Re: Dividends and options strategy

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Originally Posted by BUM
He claims his avg. client returns are above 10%. He says that that clients respond to profits and his track record is very good. Client list keeps growing. He says 99+% of his activity is strictly writing covered puts.
This strategy belongs to the class of "often succeed moderately, but sometimes fail spectacularly."

For a very interesting analysis of option writing strategies, see Taleb: "Fooled By Randomness"

OTOH, even Buffet sometimes writes puts on stocks he wants. It's just that there isn't the flow of suitable candidates to allow construction of an ongoing program.

Ha


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