Now I know why I didn’t write about this before. This was a dumb trade. There is no time value in the call, it is exactly 1.32 below the stock price.

The reason is that the ex-dividend date was two days later on the 29th. The stock would drop by nearly the dividend paid, fifty seven and a half cents a share, and the call will stay where it is. On that day, CPNO closed at 17.93 from 18.25 the day before. Dropping just 0.32.

A few days later I compounded my error. CPNO was trading at 16.90 and the call was at 0.38. If I closed out the trade, I would have a 1.98 loss on the stock, a 0.94 gain on the call and 0.575 in dividends for a loss of 0.465 plus commissions. CPNO was out of the break even zone of the buy-write.

What I did was to buy the 17.5 call and sell the 15 call for a credit of 1.55. That way I felt protected. When I closed out the trade a few days later, my loss was 0.442 after commissions. Slightly better than closing it out earlier, but not worth the extra few days.

Minnesota Mining & Manufacturing

A steady conglomerate paying steady dividends. So 29th October I thought it would pay its dividend around the 19th of November, like last year. So I bought some stock at 75.24 and sold the Nov 75 call for 1.8 giving about 2.4% of downside protection. The beta of MMM is 0.8 so you could say that we have about 3% downside protection on the S&P 500.

There was 0.24 of intrinsic value and the rest, 1.56 time value in the call.

Usually MMM announces the dividend eight to nine days before the ex-dividend date and it hasn’t announced yet.

Today, MMM was trading near 78.75 and the call at 3.9, 3.75 in the money. My return would be 1.41, so I took off the trade. My reasoning was, if the ex-date is before November options expiration, and the stock is called, I would earn another fifteen cents, but I would have to wait about nine days. If MMM dropped enough so that it wouldn’t be called, I would get the 51 cents dividend if the ex-date is before expiration.

Didn’t seem worth waiting for. What do you think? Comment below.

Now, I thought that Friday my shares would be called away by the owner of the calls. But they were not. So I collect the dividend as well as the time value of the call, a total of a dollar.

So long as CLX stays above 55 until expiration, the stock will be called away at that time, unwinding the trade. I would have preferred to have had the stock called away sooner and make a smaller dollar amount. It would have been a larger percent return, 19% annualized versus 15% annualized.

PPH

Some ETFs, like SPY, the S&P 500 ETF, collect all the dividends paid during the quarter and then pay it out at once. Others pay it out as it comes in to them. For example, tomorrow PPH, the pharmaceutical HOLDRs, pay a cash distribution of $3.96 because of the merger of Wyeth (WYE) and Pfizer (PZE). And the CBOE is adjusting the option contracts to reflect that special payment.

Here is a screen shot of the November series options (Click on the image to enlarge):

PPH is trading at 68.39 / 68.4 and the Nov 70 put is 2.1 / 2.35. The intrinsic value of the put is 1.6 so the remaining fifty to seventy five cents reflects the time value to expiration. There are 32 days until the November options expire and theta is a penny and one half, so that is $0.48. There is a regular dividend payment of $0.009 cents with ex dividend date Thursday the 22nd of October. Too small to be seen with the naked eye.

We compare the BXM Buy-Write Index with the SPTR, the total return S&P 500 index which includes dividends. The S&P index has near zero return for this time period.

The BXM return is slightly higher than SPTR, but the standard deviation of return is much lower. So the return is much less volatile, so higher quality.

Since June 1986 $1 invested in BXM would grow to over $6 while SPTR would be $5.4 and three month T bills would grow to $2.73

Why Bother?

Why try to figure out a way to capture dividends? You make pennies. But they are high quality pennies. Any time you can lock in a return, even a small one, that is very high quality money. We will do the return calculation at the end to see if it is worth it.

Today’s Target

Phillip Morris (PM) goes ex-dividend tomorrow, 24th September, paying $0.58 in a few weeks. So today is the come date. In the money call owners who want the stock will call it away today. And call owners who fear a drop in the value of the call will sell their call today.

So I thought that I would buy stock and sell calls so that the stock would be called away. I would get the time premium in the call. So I need a call that is in the money and has a small enough time premium to make it worthwhile for the call owner to call it away.

Which Call To Sell?

This is the Oct in the money call option chain, 7:30 this morning, before the market opens. (Click on the picture to enlarge.)

The 48, 47, and 46 calls are trading with the dividend payment already accounted for. Notice that their implied volatility is lower than the historical volatility of the stock. The deeper in the money calls’ bid and ask bracket PM’s price, 48.93. they have no time value left. So there is nothing to do here.

Let’s look at the Nov option chain for the in the money calls.  (Click on the picture to enlarge.)

We can make a table to make it easier to compare.

To me, it looks like the Nov calls with strikes 46 and lower will be called away. The 47s and 48s have too much time premium and so are too expensive to be called.

As a further check that this is the baseline implied volatility level, we look at Dec too.  (Click on the picture to enlarge.)

Expected Return

So buying a share of PM and selling a 46 Nov call would cost $48.93 – $3.2 = $45.78 and if it is called away, we make $0.27 time premium. So the return is approximately one half of one percent. The risk is that the stock isn’t called away.

I will report back later.

You would be very badly off.

Writing Covered Calls

On the other hand, many investors think that selling calls against stock in the account is a conservative way to earn extra interest on the stock you hold. You give up the increase in the stock above the strike of the calls you sold. So if you have a $90 stock and you sell the $100 calls for $5 this is your payoff at expiration of the options

Return of Covered Call

So if the stock ends up at 85 on expiration Friday your return is zero. If the stock is still at 90 on expiration of the call, you have earned 5. The maximum you can make is $15 if the stock goes to $100 you have earned $10 on the stock and $5 premium from the option. If the stock closes above $100 it will be called away so you forgo the appreciation above $100.

If the stock drops below 85 your loss is dollar for dollar the decline in the stock below 85.

Selling Puts against Cash

If you sell the $80 put when the stock is at $90 and earn the same premium of $5 here is your payoff graph.

Return on Selling a Put

The shape of the return is exactly the same as the covered call except that it is shifted and there is no return from the stock. The breakeven, where you get zero return, is at 75. The stock is put to you and you have to pay $80 and you have already earned the $5 premium. So selling the put is safer than writing covered calls where the breakeven was 85.

One difference between the two strategies is that you get paid the dividends on the stock if you hold the stock and sell the calls. If you are short the puts, you don’t earn that dividend. Another difference is that you have to hold the cash collateral in your account equal to 25 – 30% of the value of the stock plus the premium earned. So there is an opportunity cost there but smaller than tying up your money in paying full price to own the stock.

If you want more information like this about options, see my favorite income strategies page.

With the collapse of the market in November 2008, strong companies like Vornado (VNO) were paying out seven to eight percent. Simon Property Group (SPG) another strong company, was paying out similarly. We discussed income stocks briefly in a previous post on dividend payers.

Now credit is tight, even for good companies with strong assets.  If a REIT needs money, they can sell a building or shopping mall.  The problem is that real estate values are low now so the trusts don’t want to sell.

In December the IRS ruled that REITs could pay up to 90% of their required dividend payments in stock.  Vornado announced in January that it would pay 60% of its dividend in stock, and last week Simon Property Group said that they would pay 90% of its dividend in stock.

This is theft.

If they are paying in stock, they are not paying.

Think of the stock of a company as a cake.  Say you cut the cake into twenty slices and give everyone at the party a piece. Then each person at the party has 1/20th of the cake.  If instead, this works well with three year olds, you cut the cake into 40 pieces and give everyone one piece, you have given out half the cake.  After a half hour, you give everyone a dividend, another piece of cake.  They have had two pieces of cake, but still only 1/20th of the cake.  The dividend gave them nothing extra.

In the same way, if a company has 100 shares of stock held by the public and it gives a “dividend” of 10 shares,  it has just reduced the size of each share by ten percent because it has divided up the company into ten percent more shares.

Avoid REITs.

Mortgage REITs

I was more interested in mortgage REITs that buy guaranteed  Fannie Mae paper and repo it several times to increase their leverage and make the spread.  They are paying over 13% per share on the spread.  As long as they can borrow they can earn the spread.  They have to pay it out.  So you are getting 13% on paper backed by the government.  I held NLY through its December payout, then I sold it as the price dropped.  There is no point holding a stock for 13% dividends if it drops 15%!

Another play on Fannie Mae paper is Hatteras Financial, HTS.  It is paying almost 16% I still have that in the account because it is up so much since I bought it.  They buy short term Fannie Mae paper and repo it.  They match the duration of their funds better than Annaly does.

Their next payout will be in March, so keep an eye on these two.

Using Margin to Increase Return

You can actually earn much more than their nominal yields.  If you hold them in your account and use margin this is how the arithmetic works.  If the stock pays 13% and you leverage two to one.  You have to pay, say, 8% to your broker so you will earn 13 + (13 -8) = 18% on your money.  If you leverage three to one, you will earn  23%.  That is a very good return.

Master Limited Partnerships

Linn Energy, LINE is also paying close to 16%.  They have sold their production forward for the next three years so they know what prices they are getting for their gas.  Tht means that their payout is pretty secure.  It is a master limited partnership so the payout creates some complication when paying taxes.

To avoid those problems you can buy KYE which owns MLPs so they have all the tax complications and their payout to you is a simple dividend.  They are paying 14.7% now.  It is a little mysterious what particular MLPs they own.  They give you information on their top holdings.

Cash Rich Companies

Biovail, BVF, pays out over 13% and have a lot of cash on hand to continue paying out.  The problem with them is, they don’t know what business they are in yet.  They are looking around for something to do.  So watch this one carefully.  Set tight stops.  Their next payout is in March also.