Financial Freedom Sloth

achieving financial freedom one lazy step at a time

Tag: options

Using options when you are a dividend growth investor

It’s my not so humble opinion that options are perfect for those whom pursue a dividend growth strategy. You see, as a dividend grower who likes to buy and keep stock for a long period you get something for free with options.

The price of an option is determined by the current stock price, the intrinsic value, time to expiration or the time value, volatility, interest rates and cash dividends paid.

It’s the volatility part that is interesting part. You see, as a trader who goes in and out potions a lot volatility is indeed a risk factor for which you want to be rewarded. But as a dividend growth investor you don’t really need to care about volatility at all. All that matters is your purchasing price as that determines your dividend yield.

Volatility is the movement of the stock price: stock A which goes from 100 euro to 94 euro, then to 107 euro and then back down to 105 euro has a higher volatility than stock B that goes from a 100 euro to 102 euro and then settles on the 105 euro. For a trader the more volatility is indeed a risk as he might get forced out of a position. Both stock may start and end at the same price but the higher volatility of stock A makes it more riskier for our professional trader than stock B. As a dividend grower who is going to keep the stock for the long run, not so much. You want your dividend yield (the same for both stocks) and some long term capital appreciation (also the same for both stocks). But if you use options to buy stock A, thanks to the higher volatility, you can actually buy stock A at a cheaper price than stock B because the option premium you collect will be higher!

Buying a stock with a put

And that is not the only advantage options can give you. Playing with the strike price can lower your purchase price and playing with the expiry time can let you travel in time a bit.

A few practical examples of the fun (and bigger yield) you can have with options.

AB Inbev’s current price is 105,4 euro. Let’s say you like AB Inbev but prefer to buy it at 100 euro.
You could enter a limit order and wait, and wait, and wait. Me, I prefer to be paid to wait. So you could sell a put at strike 100. The December series still pays around 1 euro which means that until the third friday of September you have the obligation to buy AB Inbev at 100 euro a share. Deduct your premium from this and you will actually only pay 99 euro out of your own pocket. If the option is not exercised you just made a 1% return on your money just for waiting. It probably will not be exercised because as long as AB Inbev has a higher price than 100 euro in the market nobody is going to exercise this option as they can get more money for their shares by selling to somebody else at market price. Also, 1% in less than two months isn’t bad. I really have no idea why us Belgians have so much money on savings accounts bringing in next to nothing while such attractive yields still exist in the market. the only possible downside is you have to buy AB Inbev at 100 euro which will then get you a dividend yield of above 2% net (which still is a lot higher than your savings account).

But what if you want to be sure you get the shares AND pay less than 100 euro a share? That is easy, play with the strike price and expiry time. Going down the ladder here you will find the September 2018 puts. The 110 euro strike price gives you a current bid of 12,6 euro premium which means you actually buy at 97,4 euro and the 120 euro gives you a bid of 20 euro premium which means you buy at 100 euro exactly. Personally I would go for the 110 strike price.

If it gets exercised you bought at a price lower than today. If it doesn’t get exercised you just made 12,9% in less than a year (you only need to set aside 97,4 euro of your own money as the rest you get from the option premium). Actually, you do not even need all that money now! If you have a broker like Lynx which lets you use your other stocks at collateral you can even do it with money you still need to save. You need to have the money by expiry date which means you still have 9 months to save up the 9 740 euro you will need to buy the 100 AB Inbev shares. If you are able to save 900 euro a month you could already sell that put and pocket the option premium with 0 euro in the account to actually buy the shares. (American style options can actually be exercised any time before the expiry date but that does not happen a lot. And even if it would happen my broker is more than happy enough to lend me the money at a 3% interest rate. Selling the put either gets me 6% reduction on the current stock price or a 12.9% return if not exercised. I’ll risk the small chance of needing to borrow the money at 3%). You are in fact making money on money you not yet have. Perfect for a person who saves a lot of his wage and wants to invest it to achieve early retirement (hmm, I wonder where I could find somebody like that …)

So selling a put is used to lower your purchase price or play a bit with time and get you a stock in the future even if you do not yet have the money.

Selling a stock via calls

Once you own a stock it is time to take a look at calls. Selling calls is what you will do when you want to get rid of a stock because the dividend yield is too low. Or to create an additional cash flow from a stock.

Personally I would only buy dividend stocks if the dividend yield after taxes is above 2.5%. If it dropped below 1.6% I would want to sell the stock and then go on the hunt for a new one paying above 2.5%

Let’s say you already own AB Inbev. And you are not too happy with them not raising their interim dividend. But at the present 105 euro price you do not wish to sell. But 120 euro, that is a different matter. 120 euro, that might tempt you. Well, the September 2018 calls at strike 120 euro will pay you 2.2 euro. If you do not need to sell you just made an extra yield of 1.8% on your AB Inbev (and option premiums are tax free in Belgium folks!) If you do need to sell, well you got the price you wanted and now have the cash to write a put on a stock with a better dividend yield … I had a friend who usually doubled his dividend yield by writing some well chosen calls.

The fun part is you get your call premium now, when you sell the option, for a future obligation. But the premium money is yours to keep (with puts you need to leave the money in cash as it might be needed to buy the shares if the put is exercised). Since you already have the shares which you may or may not need to sell you the premium income of a call can be put to work immediately! You could perhaps use it to sell a put to buy some other shares …

A little word to the wise. While selling a put when you do not have all the money necessary to pay for the underlying stock is ok (as long as you know you can save that money by the time the expiry date comes around) do not ever do it with calls! Only sell calls on stock you own as your potential loss is unlimited.

Personally I would make an excel sheet for all my positions that calculates at which stock price my dividend yield drops below 1.6% and then go look if I can sell calls at that strike price and book some extra, tax free returns on those positions.

Why do it?

By buying dividend stock via puts and selling via calls I think you could add at least 1% to your return. That might not seem a lot for the effort you need to put in. But 100.000 euro which returns 7% during 10 years (and the return each year reinvested at the same 7%) gives you 196 715 euro.

Push your return rate to 8% and it is 215 892 euro. That is a 20.000 euro difference in 10 years. And who doesn’t like a big return?

It is also the reason why I would limit my number of stocks I buy to only 5 or 6 well chosen stocks. It is less work, and I am lazy. But putting more money in fewer stocks lets you use options. An option contract always work with multiple of 100 underlying shares so selling 1 put option on AB Inbev at strike 100 means you will need 10.000 euro to buy the shares. Having a lot of money in a few positions also means your option premiums start to become significant which means you can invest the money a lot faster where otherwise you would need to wait longer and sell additional options to get enough money to play with.

And your turn over rate does matter! The faster you can get money re-invested the higher your return will be. It is another advantage of a broker like Lynx. When an option is close to expiration and will definitely not be exercised you can always leave the position expiry but already sell a new option having your money or the underlying stock pull double duty for a week or two and save a bit on trading fees (every little thing helps).

I am not a dividend investor because of the high tax the Belgian government has on dividends (30%, auch) but if I was one I would have a highly concentrated portfolio with only 4 or 5 stocks (you can always choose a holding like GBL if you really want diversification). I would only buy new stock via puts and sell stock via calls. An excel sheet would track the dividend yield and determine at which strike price I would want to sell those calls. With only a handful of stocks the work would be minimal and your return should be 1 or 2% above those not using options …

Even if you want to skip buying the shares and you chose your strike price so that your options are not exercised (in essence being a premium hunter, which is something I do at times. Tax free money bitches!) I recommend to do it with stable dividend paying stocks. The reason being that once in a while you will get assigned and might even have to wait a few years before you can start selling calls on the stock at a profitable level. The dividend will make those years a lot more comfortable, especially if you are FIRE …

Special circumstance investing – march update

The UVX put I bought will take some time to move into a profit. And I am getting bored again.

What I did

So yesterday I sold 2 put contracts on ABI, strike: 100 and expiration in May.

This gets me a premium of 3,95 euro which is not a bad return for a 2 and a half month time period. Another 790 euro of cash added to the stash. This is actually less than 0,3% of the stash but if I can do it 2 more times I will have added another 1% to my return this year!

If I get assigned I buy a great company with a decent dividend at 96,05 euro a share. I chose the lower strike of 100 euro as I do not really want to be assigned. I do kind of have the money to pay for the shares. You see, my special construction (which I do not explain since it is highly leveraged stuff) pays me a lot of cash up front: around 38 000 USD. Financing fees will eat up around 14 000 USD during the life of the construction but in the end I should end up with around 24 000 USD in profits. I keep all this cash as cash as things can always go wrong and then I need to move fast and close the construction. But with the recent rise in stock prices I now have a nice little buffer and I abhor cash not working for me! These puts are a way to get some return and most probably still keep the cash buffer intact. I have to admit that I do like making money on money I made with money I do not own!

stack of stones

balancing my investments on top of each other

The risk of things going bump in the night

If everything goes well I’ll have made a bit off extra cash. If stocks start going down again I will close the construction (which I would do anyway) with a small profit. I will then not have enough cash for the 200 ABI shares. But if I do get assigned the ABI stock, I still have the ability to buy them with borrowed money from Lynx. This will then be the only leveraged position I have. It will be less than 10% of my total portfolio. Dividends of ABI would cover most of the financing fees for this leverage so I could keep it for a very long time. Most likely I would also write covered calls on the position, more than generating enough cash to cover the financing fees. With leveraged plays I always look at the possible downside and then determine if the risk is acceptable.

Variation on a theme

Whendoyouretire did a similar trade but at 110 euro strike. That’s actually pretty smart of him because he does want to get assigned since he is a dividend growth investor! If the stock does go higher, he will have earned one hell of a premium! Since I would prefer not being assigned I chose a much lower strike. But that is one of the main advantages of options. With put and call, sell and buy, moving the strike price or the expiry date, options actually offer you a very big pallet of possibilities for a whole lot of different purposes.

The girlfriends portfolio

I only figured out the construction in June of 2016 and I first wanted to test it out in my stash. This meant that the girlfriend was a bit late to the party. Her construction ends in March. At present prices I do not feel secure in repeating the construction for her. So yesterday I unwound the construction in her account. Total profit of it was around 7.000 USD. Not bad for 6 months. I also opened a new 1 x leveraged position (the construction was 2 x leveraged) in Monsanto with the use of CfD’s. Only 1 x leverage as I want to avoid any possibility of margin call on her portfolio in the small change that the merger between Bayer and Monsanto falls through. I am also keeping her construction profits in cash as an extra precaution and to cover the overnight financing fee’s of the CfD’s. When Monsanto moves higher and the risk of losing money on the leveraged position gets smaller I will look for a way to invest some of this cash. Financial Velociraptor did a similar merger arbitrage play but without the use of any leverage I think. The merger arbitrage of Monsanto first came on my radar when I read Berkshire Hathaway did it. But one should always do one’s own homework. I am not that impressed by the performance of Monsanto but the 2 billion USD breakup fee if the merger would not succeed convinced me. If the merger does not go through (and Bayer has 2 billion reasons to make sure it does happen) Monsanto will be sitting on a mountain of cash!

That is me done until I can profitably sell my UVXY put. Time to start concentrating on my diet!

Special circumstance investing

So after having explained my general views on investing. And why I really, really like the combination of our low interest rate environment, CfD’s and Lynx (a reseller of Interactive Brokers). I will now go into a bit more detail of what I did in 2016 with the newly discovered tools and what I am on the lookout for at the moment.

2016

I covered most of this in my post about the origin of my stash. But I’ll try to give a bit more explication on why I did it and the difference leverage made.

The first opportunity I had to use leverage was when AB Inbev made a take offer bid on SAB MILLER. They offered 44 GBP but the market had doubts so the SAB MILLER stock traded at 40 GBP. This was a 10% gap. I had no doubts that a) the take offer bid would materialize and b) this would happen in less than a year. So what I saw was the possibility to borrow at less than 3% to make around 10%. I was confident because I knew AB Inbev for more and a decade, this was the final piece of puzzle they had been putting together for a long time and they had successfully done the take over/merger with Anheuser-Busch. But I also looked at the downside and there the picture looked good as well: SAB MILLER had actually grown more in the last years than AB INBEV, the markets they operated in had more promise, they promised to apply the cost cutting culture of AB INBEV if the merger did not go through and they actually paid a dividend that almost covered my financing fee. The downside was actually not all that bad. Sure, the stock of SAB MILLER would probably drop to around 34 GBP (the price before the offer) but looking at the economics of SAB MILLER I felt confident they would be at 40 GBP within 2 years. So merger goes through: I make a nice and quick profit, merger does not go through: I’ll still make a profit but it will probably take 2 ears or more. So I bought 5000 CfD’s on SAB MILLER at around 40.50 GBP. The brexit and a change in margin requirements would force me out of the trade but in the end I still made a net profit of 8366 GBP. Less than I had anticipated but since the leveraged position was about the size of my total stash it did add a nice 4% extra return. And I made it between the end of December and mid June. the leverage made all the difference. Without it I would have been forced to find some free cash or sell other stocks. Berkshire was around 130 USD when I started the leveraged position and it was 140 USD. It had actually gone up 7% in the same time period. Not using leverage would have made me miss this run up in Berkshire Hathaway.

With the SAB MILLER position active and me not needing to work at the time I grew bored. So I tried my hand at day trading. Technically it was day trading because I was buying and selling on the same day. But actually I had identified some stock that was cheap and I wanted to buy some. I just didn’t feel too comfortable with already having a 200.000 GBP leveraged position so as soon as I made some profit I closed the position (and thus the extra leverage). I practiced a bit with Berkshire Hathaway and Coca cola. And then when Google went down to 730 USD I really had some fun with it. Real day trading is off course have dozens or even hundreds of trades and playing both an uptrend and downtrend in stock price. I just bought stock I thought was cheap and then sold with a small profit. Sometimes I only did 1 or 2 of these trades, and some days 6 or 8. I found it to be way to much work and also too much stress but I did make around 2.500 USD in profits from it (another 1% added to the stash). But it would have been much more profitable to just buy Google at 730 USD, keep it for a few months and then sell it around 780 USD. I just wasn’t very comfortable with that amount of leverage at that time.

But a friend of mine had combined everything we had learned about investing and the possibilities that Lynx offered and found a very interesting construction one could set up. I will not go into detail because it uses around 2X leverage (very, very dangerous!) and you should only do it with some very specific stocks (1 in particular is well suited for it) at certain price points. No need to feel left out as at present prices, one most definitely should not do it!

But in June 2016 the price was right and with the leverage of SAB MILLER gone I myself set up a similar construction. This would net me around 10.000 USD a 12.000 USD. With the leverage involved and the long period of the construction it is a bit difficult to determine the exact profit (or I should start keeping more detailed records, for which I am way too lazy! The construction was wildly profitable and that is good enough for me).

In-between all of the above, and because I was now making profits with my leveraged positions I also wrote a few puts on Berkshire Hathaway, none of them called because Berkshire Hathaway had a really good 2016! I would have liked to buy extra shares at a lower price but the 1 500 USD in premiums was nice as well. I did pick up some Berkshire Hathaway shares to hold and add to my collateral (all that profit had to go somewhere).

Looking at 2016, it may seem as I was all over the map. But if you discount the ‘day trading’ activity I actually did not do a whole lot of trades and I was only active in 5 different stocks. All of which I have known for years, or even decades. For me, most of the work is in identifying good companies to invest in. Once that is done, doing trades in them, even if that is with options or via CfD’s does not take a lot of time or effort. It is my long held belief that an investor only needs a handful of quality stocks he knows really, really well and a good understanding of all the possibilities of options to do very well for himself.

Thanks to the smart use of leverage I added a bit more than 10% extra return to my stash.

2017

Early in 2017 I could repeat the construction from mid 2016. This will add around 24.000 USD to my stash, or an extra 10% return. The price point at which I could do it was stretching my comfort zone somewhat. A sharp drop in stock price is the only risk I have, stock price remaining equal or going higher do not make any difference (I do have around 5% downward protection, but after that, things become dicey). At 2 times leverage I have felt a bit unsettled but we are now one month into it and prices have risen another 6% so that does give me another safety cushion!

Setting up the construction only took 5 minutes (10 if you add the time i spend on my parents stash) and then left me with not a whole much to do. I grew bored. I also came to the realization I like investing. I like it a lot. I have literally zero need to keep reading financial and economic stuff but yet I continue to read, read, read.

I miss being active and when I find something really, really smart I am not ashamed to admit I drool over it.

I am drooling over UVXY. it seems to be a product designed to go lower in price over time. Financial velociraptor found it. Which makes it ideal to short it (or buy puts on it). With the construction it is prudent to keep a decent amount of cash at hand. Especially in the beginning. At the moment that is around 40.000 USD. Over time, the leverage is going to cost me around 12.000 USD.

So me being bored, having found this really cool stock to play with and having a lot of cash available. Well, I had to try a trade in it! I copied Velociraptors last trade. It is not beneath me to copy somebody’s cool idea! So I bought three contracts of UVXY190118P00013000. We will see how it turns out. It is ideal to familiarize myself with it. The longer the construction runs, the less need to hold large amounts of cash. So starting slow with not too much cash and slowly building my confidence in these trades and making them larger as time goes by is ideal for me at the moment.

Prices of most stock are pretty high but I am looking at some stuff.

Resilux, there is a takeover bid at 195 euro and the stock currently sits at 188.75 euro. Takeover bid has the support of current management and there is a fair change it will go through. At 185 euro it would be a nice CfD play. Doubtfull it will go so low, and volume is also low but I have set an e-mail alert on it at 185,50 euro.

Vandevelde got knocked down to 57,5 euro. They pay a net dividend of 4.2% at current stock price (3.5 bruto – 30% taxes). But I do not like them paying full free cash flow in dividends, or being geographically limited (bulk of their sales profit come from Belgium and France and with the upcoming presidential election in France, 2017 may be bumpy). Still, good company with a nice product (Belgian men know what I am talking about) and well run. But too many doubts.

I almost wrote some puts on coca cola when they stood at 40,50 USD last week. I wanted a slightly higher premium and also visited some friends on the day I was planning to do it (and I forgot t take my log in information with me, doh!). Here is hoping they go back down. Last time Coca-cola was around the 40 USD price level I made around 15% in a 4 month time frame. Would like to repeat that if at all possible! Set another e-mail alert at 40,80 USD. I would write 5 put contracts at strike 40 and an expiry 5 to 6 months away. Can stocks please go a bit lower? It’s starting to become a bit ridiculous!

And then there is another takeover arbitrage possibility. Bayer wants to pay 128 USD cash for Monsanto but Monsanto is only trading at 110,70 USD at the moment. That is a nice 15% gap. It is also an arbitrage Buffett is apparently playing and he is seldom wrong. But I need to do my homework on Monsanto first. Would I mind holding the stock for some time at current price if the deal falls through? Since I am already at the max leverage I want to tolerate, this would actually be something for the girlfriends stash. So I really need to do my homework. She still hasn’t decided if she wants to actually make a profit of Monsanto as she doesn’t like the company or its products. Personally I am amoral if it comes down to investments but like I said, I really need to read up on Monsanto before risking any of the girlfriends money. If I do it, I will limit the leverage to 1X or even only 0.75X of her stash.

So this what I have done in 2017 and what I am currently looking at. Did anybody make it all the way to the end?