Let’s face it: Dividends are hard to come by these days.
It’s not surprising, therefore, that some income investors have taken to the options market to increase their returns.
More specifically, they’re selling call options on the dividend stocks they own – and it does indeed boost their income.
Of course, there’s risk, too. This method can lead to significant trouble if the market moves sharply.
Still, there are certain ways to make this strategy work. If you think the market will continue gently upwards as it has for the past five years, it should be seriously considered.
First, though, we need to understand the risk-reward profile of this strategy, as your maximum gain is limited, but your downside risk is unlimited in two cases.
If stock prices decline, you’re left with the stock at a lower price, often lower than the net buy price after subtracting the call premium on the option you sold. Further, if the stock zooms up, it’s called away from you, and your opportunity cost is then unlimited (not to mention the actual out-of-pocket cost if you want to buy the stock back).
For retirees wishing to live on their income, the biggest risk is a severe bear market that would reduce the capital value of their holdings. What’s more, if a severe bear market does occur, they’ll need to stop selling calls until the market has bounced back. Otherwise, they’ll lose their holdings before prices have recovered.
Nevertheless, if you think the overall market will remain generally directionless or trend gently upward, this technique can increase the income from your blue-chip holdings.
The Power of Options
Selling calls on income stocks is a popular strategy – and that means premiums on close-to-the-money calls (the ones sold by income enhancers) are lower priced than they should be compared to puts or more distant calls.
Plus, since income stocks tend to be less volatile, they also have relatively low option “implied volatilities” and option prices.
For those believing the market is in the right state for this technique, here are two attractive opportunities:
The Blackstone Group (BX), the leveraged buyout house, pays an exceptionally attractive $0.89 quarterly dividend, which gives a yield of 8.2% at its current price of $42.40. The ex-dividend dates are in late July and October, so if you sell December calls, you’ll get two dividends (you probably can’t get a third by selling January 2016 calls).
December $44 calls are currently bid at $1.54, for an implied volatility of a reasonable 20%. So, if you sell Blackstone December calls and your stock is called, you’ll receive a total of $1.78 in dividends plus $1.60 profit on the stock plus $1.54 option premium, or a total of $4.92, a profit of 11.6% on your investment, or 24% annualized. If you’re not called, your options have increased your dividend yield from 8.2% to a very juicy 15.6%.
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Philip Morris International (PM), the tobacco company, pays a $1 quarterly dividend and yields 5% on its current $79.70 stock price. The ex-dividend dates are in June, September, and December (the next about June 24), so you want to sell January 2016 options to get three dividends.
The January $85 options have a rather skinny implied volatility of 14%, bid at $1.38. If you’re called, your return over the seven months is $3 in dividends plus $1.38 in option premium plus $5.30 profit, or $9.68, 12.1% on your money, or an annualized 21.7%. If you’re not called, you’ll have increased your dividend yield from 5% to 7.9%.
More Volatility = More Income
Finally, it’s worth noting that you don’t need to confine this technique to income stocks.
Some of the hottest tech stocks have high volatilities on their options, which means you can make more selling calls on them than on a regular stock.
For example, you can buy Tesla Motors (TSLA) today for $249, then sell December $260 calls for $21.60 at an implied volatility of 36.4%. Implied volatility is the volatility number you get when you plug the current option price into an option pricing formula; it’s a measure of how much the options market thinks the stock will bounce about.
This locks in your Tesla acquisition price at $227.40, well below the market price. And if Tesla trades above $260 in December, your return is $32.60, or an annualized 27.9% over the six-month period. Because Tesla is considered a volatile stock, its options trade higher. Plus, since it pays no dividend, fewer people are selling calls on it.
Bottom line: Though it requires the right market conditions, this strategy can definitely boost your income. In today’s investing environment, that’s always worth a look.