Options Notes

1) must know option strategies for dividend investors

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3 Must-Know Options Strategies for Dividend Investors May 04, 2009

1. Introduction

For dividend income investors not familiar with options, here are some simple ideas you
should consider for getting higher yields with little or no additional risk.

This article is intended purely to introduce some simple, conservative options strategies
for both decreasing risk and increasing income. Dividend investors, who are often
unfamiliar with options, can then decide if these are worth further investigation. Readers
will need to do more homework before implementing these strategies, and stay tuned for
follow-up articles.

A. Options Need Not Be Risky or Complex

Most dividend income investors tend to be risk averse and prefer the simplicity of buying
and holding quality stocks with reliable yields. For most dividend investors, the very
word “options” connotes high risk and complexity.

In fact, there are options strategies that are simple, and can increase your annual yield
with little or no additional risk. The level of risk and complexity varies completely with
how you use options. It's like comparing auto racing to conservative driving. Both can be
called driving, however the risk and skill levels demanded by the two activities differ
dramatically. The same goes for options trading.

Again, used properly, stock options can actually reduce risk and increase your income.

B. Why Dividend Investors Should Consider Options

How would you like to make an additional 5%-10% or more annual yield on stocks you
already own, and plan on holding? It’s possible by selling Covered Call options, which
are just rights to buy your stock.

Are there stocks you would love to buy if they drop to a certain lower price? Rather than
simply placing a buy order at that price, you can sell a put option, which is a contract to
buy someone’s shares if they sink to a certain price. Your put option buyer gets insurance
against a price decline below that price. You get the stock you’d have bought anyway – at
a further discount equal to the put option sale price.
For overall portfolio insurance against market declines, you can buy put options on a
major index or surrogate of an index.

C. Basic Concepts

Here’s the basic vocabulary of stock options.

1. Definitions:

An option is short for an options contract, which is a formal agreement providing the
right (but not the obligation) to buy or sell a fixed number of 100 shares of a given stock
on or by a specific date called the expiration date at a specific price called the strike
price. Note that options typically trade in units of 100 shares called contracts. Thus
instead of selling options on 300 shares, you’d sell three contracts. So if you trade online,
you’d enter ”3” not 300 in the Quantity or Amount field when placing your sell order,
otherwise you’ll be selling options on 30,000 shares. Your trading platform will alert you
if your portfolio isn’t large enough to cover that, but if it is, you could make an expensive
mistake.

2. Two basic kinds of options:

A call option is a right to buy. Visualize calling someone over to give you the shares for
which they have sold you the right to buy at a given strike price and by a given expiration
date.

There are two kinds of call options. Covered calls are rights to buy stock that the seller
already owns, so he is "covered" against the risk of needing to buy shares that have
suddenly risen in price in order to fulfill his obligation to the buyer of the call option on
the expiration date.

FYI, selling naked calls means selling calls on shares the seller does not currently own,
and who risks being forced to buy shares that have unexpectedly risen in order to fulfill
his obligation, just like any short seller. This strategy IS obviously more risky and
beginners should avoid it.

A put option is the right to sell. Visualize your putting the shares into a buyer's hands.

3. The Price of an Option is Composed of Two Parts:

Intrinsic value: Is simply the REAL value of the option if exercised at a given moment.
If a stock sells for $10/share, an option to buy the stock for $5/share (i.e. a call option
with a $5 strike price) is worth about $5/share, or $500/contract, since the owner could
exercise the option and save that amount.

Only options that are in-the-money have intrinsic value.

That is, a call option (right to buy or call in) has intrinsic value only to the extent that its
strike price is BELOW the market price, because it gives the owner the right to buy the
stock below market value.

A put option (right to sell or put into the put option seller’s hands) has intrinsic value to
the extent that its strike price is ABOVE the stock price, because it allows the owner to
sell the stock above market value.

Time value: The value of the time left to exercise the option. An option is a right for a
specified time. The more time left on the option for the price go in the owner’s favor, the
more time value and the higher the option price.

4. In General, Sell Options, Don’t Buy Options:

Thus time works in favor of option sellers, and against option buyers. An option buyer
must not only be right about the direction of the market (hard enough), but the timing as
well, because the option becomes worthless after the expiration date. Thus the time value
portion of the option is always dropping.

Unless you’re buying puts (rights to sell) as insurance, option buying is a riskier strategy
better suited to those with more trading skills and/or risk tolerance than the typical
income oriented investor.

In general, conservative income investors stick to selling options, except for buying index
puts as portfolio insurance

Sell covered calls to enhance yield on stocks you own.

Sell puts in order to buy stocks you would buy at the strike price anyway in order to get
them for even less, thus enhancing yield AND reducing risk of loss with a lower cost
basis.

Below we will provide a brief introduction or review of some of the most basic options
strategies for enhancing yield, reducing risk, or both.

2. Selling Covered Calls

Did you know that it’s very possible to earn an extra 5%-10% annual yield (or more) on
stocks you already own? You could do it by selling a call option (an option to buy from
you) on those shares at a price that’s a bit higher than the current price. Because you
already own the shares, this call option is called a covered call. In other words, you’re
covered against the risk of needing to buy the shares at a price above your strike price.

A. Advantages
If you plan on holding the shares, there is no additional risk, because you’ve already
assumed the risk of stock ownership.

There are only two possible outcomes, both of which are better than simply holding your
shares.

· If, on the expiration date of the call option, the stock price rises above the price you
specified, the strike price, your stock gets called, or sold at the strike price. You’ve lost
nothing except the potential gain above the strike price. Again, if you planned on holding
the stock, you wouldn’t have gotten that anyway.

· If the stock is below the strike price at the expiration date, the covered call option
expires. You keep the stock and the sale price or premium.

In either case, you pocket the extra cash from selling the covered call option.

Obviously, we want to sell covered calls at a strike price above our cost basis, so we still
profit if the market price is above the strike price and the shares are called. Ideally we’d
like to sell at a strike price above where we believe the price will rise by the expiration
date, so that we can keep both the premium and the shares.

B. The Tricky Parts

Timing: The hard part is in the timing. The more the options are out-of-the-money, i.e.
the more the strike price is above the market price, the lower the value and price of the
option, since the buyer has a higher risk of the option expiring worthless.

So covered call sellers ideally try to sell calls at market peaks. Few are good at market
timing.

Option Price Increments: Unlike stocks, options are not sold in penny increments,
rather at increments of between $2.50 and $5.00 or more, depending on how high the
stock price. Thus you can’t always trade options at prices that will cover your cost basis
AND give you a decent return.

C. Disadvantages

When you sell covered calls, you risk missing at least some of an unanticipated rise in the
stock price. If your strike price was below your cost basis in the stock plus the cash from
the option sale, you risk a loss either from selling the stock at a loss or buying back the
call for more than you sold it.

3. Selling Put Options on Stocks You Want to Own

Is there a stock you’d like to buy once it gets down to a certain lower price? How would
you like the chance to buy at that low price, with an additional discount? You could do it
by selling a put option (option to sell to you) on that stock at that desired strike price.

A. Advantages

There are two possible outcomes, both of which are better than simply putting in a buy
order at the given price.

• If, on the expiration date of the put option, the stock price is at or below the
specified strike price, you pay for the stock at the price you wanted, with an
additional discount in the form of the premium you were paid up front when you
sold the option.
• If on the expiration date of the put option the stock is above the strike price, the
buyer does not sell to you. You got paid for providing insurance to the buyer of
the put option against a price drop below the strike price.

Again, in either case, you keep the premium from the sale of the option.

B. The Tricky Parts

Obviously, we want to sell puts at a strike price at or near strong support, at what we
consider bargain levels. Ideally we’d like to sell at a strike price below where we believe
the price is likely to drop by the expiration date, so that we can keep both the premium
and the shares.

As with selling covered calls, the tricky part is in the timing. The more the options are
out-of-the-money, i.e. the more the strike price is below the market price, the lower the
value and selling price of the option, since the buyer bears greater risk of the option
expiring worthless.

So put sellers ideally try to sell at market bottoms. Few are good at market timing.

Option Price Increments: Unlike stocks, options are not sold in penny increments,
rather at increments of between $2.50 and $5.00 or more, depending on how high the
stock price. Thus you can’t always sell put options at strike prices that are low enough to
want to buy the stock, AND to get a good premium on the sale of the put.

C. Disadvantages

When you sell a put, you risk “catching a falling knife,” that is, being obligated to buy a
stock after its price has plummeted, and you wind up taking a loss either from buying a
stock well above its market value or buying back the option for more than you sold it.

4. Buying Put Options on Stock Indexes or Their Surrogates for Overall

Portfolio Insurance
Even an introduction to this strategy requires its own article, since this strategy can get
complicated. For now, know that you want to take a certain portion of your dividend
yield and use it to buy put options on an index or surrogate for one. For example, if you
own a general portfolio, puts on the S&P 500 index or SPYs would work. Those heavy in
energy would seek to dedicate a portion of their dividends to buy puts on something
tracking energy. The idea is to get some insurance without gutting your returns. More on
this at a later time.

5. Options are Not Always Available

You may not be able to trade options on thinly traded and/or foreign shares, especially if
you only trade on U.S. exchanges. Fortunately many of our recommendations do have
options, including most of the more liquid foreign ones.

BP, plc (BP), CNOOC Ltd. (CEO), Enid SpA (E), Total Fina Elf (TOT), Veolia
Environmental SA (VE), AT &T Inc (T), Verizon (VZ), Otelco (OTT), Windstream Corp
(WIN), Buckeye Partners (BPL), El Paso Pipeline Partners (EPB), Enterprise Products
Partners (EPD), Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP),
Magellan Midstream Partners (MMP), Nustar Energy (NS), ONEOK Partners (OKS),
Sunoco Logistics Partners (SXL), TEPPCO Partners (TPP), Tortoise Energy
Infrastructure Partners (TYG), Alliance Resource Partners (ARLP), Natural Resource
Partners (NRP), Penn Virginia Resources Partners (PVR), Terra Nitrogen Company, L.P.
(TNH), StoneMor Partners (STON) Dominion Resources Inc. (D), Duke Energy Corp
(DUK), Progress Energy (PGN), Southern Company (SO)

6. Sources for Further Study

If the above strategies sound intriguing, you'll need to do more homework. Here are a few
free sources for getting started.

A. Free Online Resources

Any internet search using various combinations of terms as

• "stock options" AND (introduction OR guide OR beginner)

• "options" AND "investing
• "options strategies" AND stocks

will provide you with numerous well written, more detailed introductions to the topic. A
few sites to browse for introductions to options and terminology can be found here, here
and lastly, here, (for ordering the books mentioned below and further materials for
implementing his strategies).

B. Books
There are many. Here are a few suggestions that would be an excellent start for high
dividend and others who invest in stocks for dividend income.

Show Me the Money: Covered Calls & Naked Puts for a Monthly Cash Income by Ron
Groenke, Keller Publishing, 2004: (Order via www.rongroenke.com or other online
sellers). I actually read an earlier version called Covered Calls and Naked Puts, this is an
updated version.

This book is one of the most mercifully clear, jargon-free and concise introductions to
simple options strategies for income, yet at the same time provides fairly detailed
explanations of how to implement the strategies discussed. Written as the story of a
retiree who reunites with his old college Finance Professor in a Florida retirement
community, the author explains his techniques through dialogues between the two men.
The story slows down the information flow a bit, but many will find the book far easier to
read than a typical book on the topic.

Put Options by Jeffrey M. Cohen, McGraw Hill, 2003. The best book I’ve found on how
to use puts for both income reduction and risk. Some new twists on using puts, very
worthwhile specifically for conservative, risk averse income investors. Great ideas, clear
and well explained.