This chapter is from the book
This chapter is from the book
This chapter is from the book
Dividends and Puts
Most traders who buy calls know that dividends have a negative impact on premium value. This occurs when the stock goes ex-dividend, the day when the dividend is factored into the share price. However, while this is a negative factor for call buyers, it is a positive one for put buyers.
Since dividends reduce the share value of stock, in-the-money calls are expected to also lose value. But because puts increase in value as stock price falls, an in-the-money put will increase in value at ex-dividend date. This reality may affect the timing of many put strategies. Knowing in advance that the put’s value will fall because ex-dividend date is looming builds in extra premium appreciation beyond the normal cause and effect of price change in the underlying. The strategy of timing with a dividend in mind is the same for long puts as it is for short calls; a decline in the stock price is predictable, so the long put will increase in value (beneficial to its owner or buyer) and the short call will decline in value (beneficial to the seller).
Dividends are often overlooked as a factor in both the selection of options and the timing of trades. This is a mistake; dividends represent a significant portion of potential profits on both stock trades and option trades. For example, if you select a stock paying a relatively high dividend (4 percent, for example), ownership of the stock includes an ensured 4 percent annual return. This is even greater if the dividends are reinvested in partial shares, which converts the nominal rate into a compound rate of return.
Dividend income is also significant when considering the relative value and likely outcome of a put strategy that includes ownership of stock. You earn dividends only if you own shares of stock, so this extra consideration applies only when strategies include long stock positions in conjunction with long or short positions. When you compare likely outcome in a number of scenarios, include dividend income in the equation.
For example, you may construct an option strategy combining a long stock position with either long or short puts, or with puts and calls in spread or straddle positions. If you are looking at several different companies as potential candidates for such a strategy, including the dividend income often makes a substantial difference. Assuming that the assumed value of each issue is comparable, a dividend-paying stock is likely to produce a better overall yield than a stock that does not pay a dividend (or one paying a much smaller dividend).
In coming chapters, return calculations include dividend income as a means for comparison. For example, if three different stocks using the same strategy are assumed to produce a range of returns between 7 and 8 percent, a 3 percent dividend on one stock will make it the clear winner in overall income.
Besides augmenting total income from a combined stock and option strategy, dividends create a cushion of downside protection in the stock position. Stocks held for many years grow significantly in value when quarterly dividends are reinvested and when additional income is generated through option strategies. Many of these combined strategies are quite low risk and may produce consistent cash income representing double-digit returns (including dividends), but with little added market risk when compared to simply owning shares of stock.
Comparing Risk Levels
Any option strategy should be analyzed with risk in mind. Any single-option long position contains a specific market risk, based on the fact that most are going to expire worthless or be closed at a net loss. The effects of declining time value make it very difficult to profit from buying options for speculation.
Many additional reasons for buying puts can justify the market risk. For example, protecting paper profits in appreciated stock by buying puts provides a form of insurance. If the stock price does retreat, appreciated put value offsets the decline in value; the put can be closed at a profit to recapture the paper profits lost; or it can even be exercised. This allows you to sell 100 shares of stock for each put owned, at the fixed strike price. So as long as the strike is higher than current market value, this type of long put position hedges the stock position. In a volatile market, this can be a valuable strategic move; it can make long stock positions more acceptable even with high volatility in the market because potential losses are insured against as long as the put position remains open.
Additional advanced strategies combining long puts with stock, with short puts, or with calls can also make the long put valuable as a source for potential profits or as a means for limiting risk in the overall position. So puts serve as a device for reducing profits in numerous stock and combined option positions.
Risk comparison should also be made between short puts and short calls. Writing naked calls is one of the highest-risk option strategies because, in theory, a stock’s market price can rise indefinitely. This means that the true risk of a naked call is unknown. It is defined as the difference between market value of the stock and the short call’s strike price, minus the call’s premium received when the position was opened:
- (current value, 100 shares − strike price, short call) = short call risk
This is “unlimited” because you cannot know how high the current price per share is going to reach. So uncovered calls are high risk. In comparison, a covered call is not only low risk; it is exceptionally conservative. By definition, a call is usually covered when you also own 100 shares of the underlying. In the event of exercise, you simply give up the 100 shares of stock at the strike price. So as long as the strike is higher than your original basis in the call, you profit with exercise from three sources: capital gain on the stock, premium on the short call, and dividends. Covered calls produce annualized returns in double digits in many cases because time value decline translates to higher profits for the call seller.
A short call is also “covered” when you own a long call that expires on the same date or later, and at the same strike. If the strike is higher, the risk is limited to the difference between the two strikes. For example, if you sell a May 55 call and buy a May 60 call, upon exercise you would exchange 100 shares at 60 for 100 shares at 55; your risk is limited to five points ($500). So a “covered” call based on short and long positions is usually only a partial reduction of risk. The difference in strikes combined with the net credit or debit normally translates to a net risk, but a relatively small one.
Short puts also contain risks and cannot be truly covered in the same way as calls. This means that while a short call is covered with 100 shares of long stock, a short put is not as easily made lower risk. However, short puts are not as risky as short calls, a fact often overlooked by those who want to go short on options. A short call may end up in a loss position, but the loss is not indefinite. A stock can fall only to zero, so a lower strike price represents a lower “worst case” risk. In a practical sense, the true risk of a short put is not really zero; it is actually the tangible book value of the stock. For example, if a stock is selling today at $34 per share and tangible book value per share (net worth less intangible assets) is $11 per share, the true maximum risk is $23, before considering the put premium received when the position is opened. If you receive a premium of 4 ($400) when you sell a put, the net tangible risk is 19 points:
- ($34 − $11 ) − 4 = 19 ($1,900)
If the entire premium is nonintrinsic (meaning the stock’s market value was at or higher than the strike when the put is sold), this maximum risk is quite unlikely. As time moves on and expiration approaches, time value falls and the short put loses value.
Risk is further mitigated by rolling techniques. If the short put does go in the money, exercise can be avoided by closing the position or by rolling it forward. Short call sellers roll forward to a later exercise date, or forward and up to a higher strike to avoid exercise; short put positions are rolled forward to a later exercise date, or forward and down to a lower strike. Although rolling extends the period of exposure, it can result in an additional credit while avoiding exercise.
Considering the limited risk between strike and tangible book value per share, the decline in time value, and the ability to avoid exercise through rolling, short puts—often considered high-risk strategies—are actually not that high risk. This is especially true when the short put is combined with other stock and option positions, which are explored in detail in later chapters.
The point to keep in mind about risks and puts is that strategies can be devised and designed to match your risk tolerance quite well. The purpose to any strategy should be understood and carefully articulated. In a volatile market, puts can be used to protect long stock positions, take advantage of exceptionally wild price gyrations, or simply to speculate on a rapidly changing market. For management of your portfolio, short and long puts serve many purposes and, when used appropriately to reduce risks, hedge other positions, or maximize income opportunities, can enhance profits while holding risks to a minimum.
Many stockholders have a sense of helplessness when markets become volatile, especially when the volatility takes market-wide prices to the downside. Widespread apprehension keeps many people out of the markets, awaiting further developments even if that means missing exceptional opportunities. Using puts in place of adding new positions to a depressed portfolio not only makes sense financially, but also enables you to control stock without needing to commit funds, protect paper profits, and create short-term profits even in the most unpredictable markets.
The next chapter examines risk hedge as a basic put strategy and shows how proper use of puts offset (and in many cases entirely remove) risk from other portfolio positions.