# A thought on options and dividend payers



## moneymusing (Apr 3, 2009)

I've been studying the Canadian Securities Course for personal interest and have recently been reading about Options. My idea is about writing puts on good dividend paying stocks. 

Let's take for example BMO current close at $34.25

1. Write 1 Oct 36 Put contract (premium at $5.75)
2. Collect the $575 premium

If stock is above $36 at expiration, the put will expire worthless and you keep your premium.
If stock is below strike price, the put will be exercised and you are required to buy the share at the strike price of $36 (minus the premium).

So if you focused your puts on solid dividend paying stocks you can earn money on premiums and even if the stock price decreases you still end up with a decent stock.

Of course, the fundamentals of the company could change in the interim and drive the price down deservedly and you're still on the hook at the higher price. But if the fundamentals stay as they are you still get a decent stock with a reasonable growth/yield to it.

After writing this out it seems that is what you would call a naked put, but you would still want to have the cash or equity on hand if/when the put is exercised. 

I haven't actually played with options. Just thinking out loud and interested to see what others think about option strategies.

cheers


----------



## FrugalTrader (Oct 13, 2008)

This is basically the same strategy as Derek Foster in "money for nothing". Alternatively, you could buy a dividend stock then sell covered calls. Collect the premium and only forced to sell if it ends up above the strike price at expiration.


----------



## moneymusing (Apr 3, 2009)

So a covered call might actually be better than a naked put because then your money is already invested in the stock.

If the price goes down, collect your premium, and continue holding the stock earning dividends.

If the price goes up, selling the stock at a profit plus premium collected.

The problem then being that you're no longer holding the stock earning the dividend and you've got a capital gain on your hands. I'm betting the tax situation is pretty messy with this type of stuff


----------



## CanadianCapitalist (Mar 31, 2009)

Like FT points out, that's essentially the Derek Foster strategy. I don't have any problems with it as the risks are understood (as your comments indicate you do). But it is still not a free lunch and I don't think such a strategy is necessarily superior to buy-and-hold over a long time period.


----------



## FrugalTrader (Oct 13, 2008)

moneymusing said:


> So a covered call might actually be better than a naked put because then your money is already invested in the stock.
> 
> If the price goes down, collect your premium, and continue holding the stock earning dividends.
> 
> ...


The solution to the tax mess is to sell the covered calls within a tax sheltered account (RRSP, TFSA).


----------



## Preet (Apr 3, 2009)

Options are poorly understood. Did you know they were originally created to reduce risk? However, many strategies today focus on speculation.

A universal truth is that the higher your expected return, the higher the risk. (Note that higher risk does not necessarily equal higher potential return though.) Options, when viewed as a tool to tailor the risk/return of a portfolio, can be quite useful - but they require lots of education, paper-trading and monitoring.

But just to add some info - writing an OTM put does have the risk of the underlying's price crashing, and you being assigned. But you can hedge that risk by purchasing a deeper OTM put. If bought at the same time, it will be cheaper than the premium you earned on writing the shallower OTM put. Notice? Lower reward potential and lower risk.


----------



## moneymusing (Apr 3, 2009)

Preet said:


> A universal truth is that the higher your expected return, the higher the risk. (Note that higher risk does not necessarily equal higher potential return though.) Options, when viewed as a tool to tailor the risk/return of a portfolio, can be quite useful - but they require lots of education, paper-trading and monitoring.
> 
> But just to add some info - writing an OTM put does have the risk of the underlying's price crashing, and you being assigned. But you can hedge that risk by purchasing a deeper OTM put. If bought at the same time, it will be cheaper than the premium you earned on writing the shallower OTM put. Notice? Lower reward potential and lower risk.


I do follow what you mean. I might try paper trading, but am far away from making this my wealth accumulation strategy. There is a lot of learning on my end around options. And it is another zero-sum game that might not be worth playing.

Is the Derek Foster book worth reading. I read through the first book, it was fairly quick read with nothing too ground breaking. IMO


----------



## FrugalTrader (Oct 13, 2008)

Preet said:


> But just to add some info - writing an OTM put does have the risk of the underlying's price crashing, and you being assigned. But you can hedge that risk by purchasing a deeper OTM put. If bought at the same time, it will be cheaper than the premium you earned on writing the shallower OTM put. Notice? Lower reward potential and lower risk.


Preet, what are your thoughts on buying strong dividend blue chips that you want to own anyways and writing covered calls (in a tax sheltered account)? I guess the only risk then is on the upside and potentially being forced to sell upon expiration?


----------



## mfd (Apr 3, 2009)

I'm interested in covered calls as well. I know someone at work following that strategy and he's done alright even with the market swinging all over the place.


----------



## Preet (Apr 3, 2009)

Writing covered calls on blue-chips works great in a down market, and a sideways market, but in a bull market you will get called away more often so you will lag on the upside. If you write deep OTM calls (to avoid being called away), then your premium goes down. Again, the trade-off.

Also you won't be forced to sell on expiration unless you are trading european options. American options are exercisable any time (european on expiry only), but in both cases the exercise would only happen if the option is ITM (sorry, ITM = In the money, OTM = Out of the money).

Note that some people who get called away, will turn around and write deep ITM puts to re-secure the position. Deep ITM gives you a large premium (since they are already in the money), but there's more to that discussion too.

Anyways, if you think we are nearing a bull run, you may want to second guess writing covered calls.

If you want a book to read on options, Mark Wolfinger's Rookie's Guide to Options is a great place to start.


----------



## FrugalTrader (Oct 13, 2008)

Preet, you mentioned that American options can be called away at any time, especially when it's ITM. How often does this happen? Do call option buyers typically wait until expiration?


----------



## hipfan (Apr 7, 2009)

It's funny this topic should come up today... I just wrote my first covered call.
I have been wanting to do this for awhile, and finally decided to go for it today.

My primary goal is to get called and keep the premium, so I chose the at-the-money option, which is almost all time-value. I would also have no problem holding TD long term, if I don't.

Bought 100 TD @ 44.09 (+9.99 commission)
Sold 1 TD OCT09 44 call @ 4.80 (+11.24 commission)

Net cost (downside breakeven): 39.50
TD's $2.44 dividend yields 6.18% at a purchase price of $39.50, which is not too shabby, if I have to hold long term.

If I get called, this endeavour would return:
10.18% if I get called just before the first dividend payment (85 days) (43.7% annualized)
11.56% if I get called just before the second dividend payment (176 days) (24% annualized)
12.94% if I get called at expiry (191 days) (24.7% annualized)

(yes, I'm a personal finance geek)

Note1: This was in my TFSA.
Note2: I have other long exposure to the Canadian banks in my portfolio to catch the eventual rebound.


----------



## FunkyBeats (Apr 5, 2009)

I've been thinking of doing something similar to you for while, it just makes sense as an addition to my core buy and hold strategy. Bank stocks would be preferable but some resource stocks look like better option premiums. The downside is lower dividends, not sure the best way to go yet.

Investing is fun!

FB.


----------



## archanfel (Apr 7, 2009)

hipfan said:


> It's funny this topic should come up today... I just wrote my first covered call.
> I have been wanting to do this for awhile, and finally decided to go for it today.
> 
> My primary goal is to get called and keep the premium, so I chose the at-the-money option, which is almost all time-value. I would also have no problem holding TD long term, if I don't.
> ...


I would like to understand this better. 

Let's say I buy and hold TD and let's ignore dividends for a minute since we can both get them.

If TD goes bankrupt tomorrow, I would be out $44.09. You will be out $39.50.
If TD stay at $44. I would be break even. You would make $4.50. 
If TD goes to $50. I would make $6. You would make $4.50. 
If TD goes to $88. I would make $44. You would make $4.50.

In other words, comparing to buy and hold, you traded downside risk for less upside growth. Is that correct?


----------



## hipfan (Apr 7, 2009)

archanfel said:


> I would like to understand this better.
> 
> Let's say I buy and hold TD and let's ignore dividends for a minute since we can both get them.
> 
> ...


So, of course, today TD goes up 5% and my covered call limits my participation... But I knew that going in and October is still awhile off...

Yes, I traded some upside for a fixed maximum return and some downside protection. In today's markets, TD could have just has easily gone down 5% (and may still). You can choose the strike price, and expiration to suit the risk/reward profile you are looking for. 

The covered call I wrote is a pure income strategy, since I sold the at-the-money call. If you sell an out-of-the-money call, you could participate in some growth, at the expense of receiving less premium.

It's hard to compare covered call writing to buy-and-hold (B&H). B&H is a long term strategy, while the covered call is relatively short term. 

Let's look at the possible outcomes:

Consider the downside: (price of TD < $39.50) I like TD, and am prepared to hold it indefinitely if I don't get called. I don't think I would attempt this with a stock I didn't want in my portfolio anyway. I get the stock at a better price & dividend yield than B&H.

Consider the upside: (price of TD > $39.50), I get a 0-13% return (13% if price of TD > $44).

What are the probabilities of these 2 scenarios? Nobody knows for sure, but I think TD will finish above $44, and I'll make 13% (over 6 months). The further above $44 you go, the lower the probability of reaching that price gets. So B&H is a huge win if TD's price is $88, but I think the chance of getting there is remote (before Oct 17, anyway). Your point is taken though... TD @ $55 has a reasonable chance of happening in that timeframe.

I guess the point is that I put up $4400 hoping to get a short term 13% return. It's not really reasonable to compare it to a buy & hold strategy, since the goal of each strategy is different. Either way, I think it will be interesting to watch how the strategy unfolds.


----------



## ethos1 (Apr 4, 2009)

Hipfan, to add on TSX:TD, I personally think you have a good idea selling the contracts & holding the stock

Just looking at your scenario, I came up with this

The closing price on April 9 on TD was $46.75

If I was to sell the long CC Jan 2011 $46, I would get approx $6.30 in option money, this would net me $5.55, provide a downside protection to $40.45, the stock can pop & I could get called before the contract expiry, which provides me with a nice return.

If I can pick up even one quarterly dividend before getting called - I'm totally in the money

Preet mentioned selling ITM CC could get you called real quick, so with long CC either ATM or ITM does it really matter

Too me based on this approach, selling ITM options and getting called real quick is a no brainer, its just a higher ROI

Archanfel is using the 'what-if' the stocks tank. Then cover yourself by buying out of the money puts


----------



## archanfel (Apr 7, 2009)

hipfan said:


> So, of course, today TD goes up 5% and my covered call limits my participation... But I knew that going in and October is still awhile off...
> 
> Yes, I traded some upside for a fixed maximum return and some downside protection. In today's markets, TD could have just has easily gone down 5% (and may still). You can choose the strike price, and expiration to suit the risk/reward profile you are looking for.
> 
> ...


However, if you keep on doing this, would you expect that you can beat buy and hold in the long term? I am more interested in long term investment, so I am wondering whether I can keep on doing this for like 30 years. I currently hold a bunch of bank stocks as long term investment, should I be doing this to increase my potential return or do you think it limits my upside potential too much?


----------



## ethos1 (Apr 4, 2009)

archanfel said:


> I currently hold a bunch of bank stocks as long term investment, should I be doing this to increase my potential return or do you think it limits my upside potential too much?


Are you holding the regular stock or preferreds & are these US or Canadian banks?

I was just wondering since you seem to be in it for the long haul, whether you've considered the 'what-if' banks cut their dividend (like BAC did in the US), would this not quickly reflect in the bank shares dropping?

On optioning bank shares, the only downside as oppose to straight buy & hold is that your options may get called, and you have to give your shares away at a price lower than what the stock appreciated to.

Now, whether thats good or bad, depends on your investment strategy


----------



## archanfel (Apr 7, 2009)

ethos1 said:


> Are you holding the regular stock or preferreds & are these US or Canadian banks?
> 
> I was just wondering since you seem to be in it for the long haul, whether you've considered the 'what-if' banks cut their dividend (like BAC did in the US), would this not quickly reflect in the bank shares dropping?
> 
> ...


Mostly Canadian common shares. No US, although they were damn tempting for a while. 

Yes, the risk is still there. However, the risk is being balanced by the potential of higher return. Whether it's worth it? Who knows. 

The concern I have with selling call option is that it takes away the potential of higher return, yet doesn't lower the downside risk by much. I don't think it's a bad strategy, but I am not sure whether I should pursue it long term rather than doing buy and hold.


----------



## ethos1 (Apr 4, 2009)

archanfel said:


> Mostly Canadian common shares. No US, although they were damn tempting for a while.
> 
> Yes, the risk is still there. However, the risk is being balanced by the potential of higher return. Whether it's worth it? Who knows.
> 
> The concern I have with selling call option is that it takes away the potential of higher return, yet doesn't lower the downside risk by much. I don't think it's a bad strategy, but I am not sure whether I should pursue it long term rather than doing buy and hold.


One suggestion that I can think of is to look at buying call options on the same stocks that you hold, rather than sell covered calls

or consider buying puts on those same stocks to give you a downside protection

Somewhere else on the threads you mention SPY options, specifically buying 'at the money' calls, and I was wondering if you see SPY as a trading opportunity or possibly have looked at or considered a no-cost buy & sell call spread in the same calendar month?

You may have you noticed that SPY swings quite a bit during a day. so could this be an opportunity for someone to place an order to buy and to sell a _one-dollar spread _at the same price option money

Examaple only: place orders to buy the $85 call at say $15 and sell the $86 call at $15 (1 contract = 10 shares)

If this worked in your favor you'd have a zero cost/no loss position with an upside of 1$ profit for each share 

I suppose also that this could be repeated in a similar way on the put side 

What are your thoughts on this approach?


----------



## hipfan (Apr 7, 2009)

So, an update...

TD has continued to rally to 47.90, up almost $4 since I bought the stock (at 44.09) and wrote the OCT 44 call.

I had previously thought that since the option is now $4 in the money, I would have to wait to be called to get out profitably...

The ask price of the option is 6.85, and I originally sold the option for $4.85, so I'm only down $200 on the option, while I'm up almost $400 on the stock. 

The original 4.85 was all time value, but now that time value has been reduced to 2.85 (6.85 option price - $4 in the money).

So I'm up $2 in 3 days, which is 40% of the maximum profit I could hope to achieve. 

Here are my options:
1. continue to hold for 6 months to get the other 60% ($2.85) (13% total return)
2. take the $2 and just hold TD, or 
3. take the $2 and write the OCT 48 call for $4.25 (11% for 6 mo, 16% total incl the $2 for 6mo)

hmmm...


----------

