Selling options have far more upside than holding onto dividend stocks
Dividend investing is a great concept. You buy a company’s stock and receive a dividend payout once in a while. Most companies give a quarterly dividend to their shareholders while some companies give their shareholders monthly or annual payouts.
The idea is that you invest your money once, and you keep getting dividends as a reward. Reinvesting those dividends into the stock will result in a higher dividend payout next time, and most companies raise their dividends each year.
However, you are leaving significant money on the table if you only buy and hold dividend stocks. Selling options allows you to maximize your returns without taking on too much additional risk.
For this analysis, we will take a look at three stocks: Apple, AT&T, and Cisco. Each company caters to a different dividend investor. Apple is considered a dividend growth stock. You have the most stock appreciation potential with Apple and they have enough space to continue raising their dividend. This makes up for the fact that Apple currently sports a paltry 0.68% dividend as of writing.
AT&T is an income investor’s play. Although you won’t get much appreciation with the stock, AT&T does offer a juicy 7% dividend yield. AT&T raises its dividend by the bare minimum, but many income investors don’t mind since they start with a 7% yield.
Cisco is in between those two stocks. They won’t grow as much as Apple, but they have a respectable 3.5% dividend yield with some growth still on the table.
Most people would collect the dividend, hope the stock appreciates, and be on their merry way.
But if you sell options, you can dramatically increase the return you get from these stocks.
Options work in multiples of 100. In other words, you’ll need at least 100 shares of one of these companies before you can start selling options. Naked calls and puts allow you to get started without owning the shares, but that is a risky business which isn’t the best place to start.
The two strategies we’ll talk about are covered calls and cash-secured puts. There’s very little risk with these strategies and plenty of upsides.
To start, we’ll say that you already own 100 shares of Apple, AT&T, and Cisco.
For Apple, you can currently sell a covered call expiring on September 18th with a strike price of $125 and get a $4/share premium. Since you need 100 shares of Apple to sell the covered call, this represents a $400 premium.
Apple is currently $120.96 per share. Receiving $4 for each share gives you an instant 3.3% return.
In two weeks, the option will expire. If Apple’s stock does not reach $125, you get to keep your shares and the premium. If Apple stock rises above $125, you have to sell your Apple shares at $125/share no matter how high they go.
Since you already have 100 shares, you’re covered, hence the term covered call.
Apple rising from $120.96 to above $125 within 2 weeks is very reasonable which is why the premiums are higher. You can move the strike price further away from the current price to increase your chances of keeping the shares. However, moving the strike price further away from the current price will decrease your premium.
Selling an Apple covered call expiring on September 18th at a $130 strike price only gets you a $1.12/share premium which is still nice. If Apple gets above the strike price, you do sell the shares, but you also get the stock appreciation up to the stock price.
If Apple goes from $120.96 to $135, you get all of the appreciation from $120.96 to $130 if you pick the $130 strike price. That’s an extra $9.04 per share in addition to the $1.12/share premium.
In total, you would make $10.16/share with this trade which is good for an 8.4% gain in two weeks.
Cisco and AT&T don’t command those same premiums, but since there are more stable stocks, it’s easier to buy them back at an attractive price if you end up having to sell them.
Cisco has a $0.91/share premium for a put contract expiring on September 18th at a $41 strike price (Cisco currently trades at $40.82).
AT&T has the lowest premiums since its stock price barely moves. It’s September 18th $29.50 strike price contract currently commands a $0.52/share premium (AT&T is currently priced at $29.42/share).
Here’s the list of premiums for the contracts we discussed:
Apple — $4.00/share = $400 premium
Cisco — $0.91/share = $91 premium
AT&T — $0.52/share = $52 premium
All of these premiums represent what you will make for selling a covered call that will expire in two weeks. You either get to keep the stock or you sell your shares but get to add some of the stock appreciation to your total return.
Now let’s look at how much these companies pay in annual dividends…
Apple — $0.82/share = $82 per year from 100 shares
Cisco — $1.44/share = $144 per year from 100 shares
AT&T — $2.08/share = $208 per year from 100 shares
Since Apple’s stock price has significant movements, it’s easy to find a premium that exceeds the annual dividend. In this case, the $400 premium is almost 5 times the annual $82 dividend for buying and holding the 100 shares.
Cisco’s $91 premium for the contract expiring in two weeks is more than half of the annual dividend.
AT&T’s $52 premium is a quarter of the annual dividend. Rather than wait for the dividend to come, you can do a covered call to essentially get your dividend payment right away.
If you sell the stock, you won’t get the dividend income unless you buy back those 100 shares. But rather than buy them back at their heightened prices, you can wait for them to go down in value…and get paid for it.
Most investors waiting for a stock to decline will create a limit order. In a limit order, you tell your broker that you will only buy XYZ stock for $100 and nothing more. If XYZ stock goes down to $100 or lower, your order is automatically filled.
Let’s say Cisco shares go up to $45 and you were forced to sell your shares at $41/share. While you miss out on $4/share appreciation, you do collect the premium which lightens the blow.
But you really want to get your Cisco stock back at a reasonable price. In this case, you can sell a cash-secured put with a strike price of $41. Instead of buying 100 shares, you just need to put down $4,100 which is enough cash to buy 100 shares of Cisco at $41/share.
This put contract gives someone the right but not the obligation to sell you 100 of their Cisco shares for $41/share. While this deal may not make sense today, it will make more sense if Cisco’s stock plunges to $38/share before the put contract expires.
In this case, the contract would get exercised and you’ll end up buying 100 Cisco shares $41/share. This trade puts you back to where you were prior to the covered call with one caveat…you also got all of the premiums.
While you will earn less of a premium for distancing your strike price away from the current stock price, a 2–4-week expiration date’s premium is still likely to beat the quarterly dividend you would have received if you kept the shares.
This is Warren Buffett’s favorite way to buy shares as you essentially get paid to buy the shares at the price you want to buy them. If the option doesn’t get exercised, you can do it all over again while collecting premiums until you end up with the 100 shares.
When you do end up with the 100 shares, you can sell a covered call and continue the cycle.
One caveat to options trading is the capital gains tax. This is the main reason some investors opt against covered calls. While the Apple stock split put me in a position to sell covered calls if I desired, I’d have to pay capital gains on all of the stock I sold.
That includes the massive run-up before the split took place, and since I’ve had almost all of those shares for less than a year, I don’t want to pay the higher capital gains tax for owning the shares for less than a year.
Similarly, I have no issue with issuing covered calls for new positions or current positions that enter the red. When Fastly became a net loss on my portfolio, I sold a far out of the money covered call that expired in 2 days.
I made $9.45 and ended up keeping the shares. Since Fastly is a growth company with a lot of upside potential, you can get higher premiums even with an expiration date that’s 2 days away.
All premiums are considered short-term capital gains unless you hold onto a contract for over a year. Contracts held for more than a year command high premiums because it’s impossible to know what will happen to a stock’s price over the course of 365 days or more (for some stocks, you can buy and sell options that expire in almost 2 years).
Since I received the $9.45 from the Fastly covered call on an option that expired in two days, that will be taxed as a short-term capital gain.
Fastly doesn’t provide a dividend to its shareholders, so it’s certainly better than nothing.
When you hear about options being risky business, those people are talking about buying options and selling naked options.
Covered calls and cash-secured puts are two of the least risky ways to invest in stocks and present great upside that can easily beat the common buy and hold approach of dividend investing.