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 …