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Defending Your Virtual Portfolio With Dividends (Members Only)

In uncertain markets, dividends can give you a critical investing edge.

As you can see from the chart on the left, just mindlessly investing in dividend-paying stocks can give you more than a 2:1 annual advantage in your investments

Of course, here at PSW, we teach the art of selling options premiums – something that turns virtually any stock into a "dividend" payer.  For example, MSFT is only a small, 2% dividend-payer but a fairly solid cash-machine of a stock that we don’t feel is likely to go bankrupt overnight so it makes for a nice safe staple in a long-term virtual portfolio.  But MSFT is also a very poorly-run company that hasn’t grown in 20 years but we can make it a much more interesting stock by simply selling covered calls.

For example, we buy MSFT for $24.23 and we sell the Sept $24 calls for .77.  This lowers our effective basis to $23.46 and selling the call puts us in no special danger – we are simply agreeing to sell MSFT for $24 on expiration day in September (the 17th).  Should the stock be called away from us, we make a .54 profit or 2.3% of our net $23.46 cash investment in less than 30 days.  That works out to a 26% annualized ROI and, even if we get called away, we can simply buy the stock again and again and sell calls every month.  Of course, you can optimize all this with timing and we favor stocks that are on sale – this is just a very simple example of how our most basic options strategy can drastically boost your annual returns on any stock in your virtual portfolio.

Let’s say you don’t want to mess around with MSFT every month.  You can simply sell the 2012 $22.50s for $4.40, that drops your net entry from $24.23 to $19.83 and getting called away at $22.50 would be a profit of 13.5% over 17 months PLUS you would be getting your .52 annual dividend so let’s call it .75 more for a total profit (if MSFT holds $22.50) of $3.42 or 17.25% – 1% a month certainly beats what the banks are offering these days!  Not as sexy as the 26% ROI you make by working the trade every month but you do get a built-in cushion that drops your break-even price to $19.83, which is a full 18% below the current price.  So MSFT would have to fall 18% (not including the .75 dividend) before you are even behind on this trade. 

Would making 1% a month on your entire virtual portfolio have enhanced your lifetime earnings?  If so, you should probably be using  this strategy whenever possible, right?  Here’s a nice chart showing average annual S&P results for each decade:

  Price
Change
Dividend
Dist. Rate
Total
Return
Inflation Real
Price Change
Real
Total Return
1950′s 13.2% 5.4% 19.3% 2.2% 10.7% 16.7%
1960′s 4.4% 3.3% 7.8% 2.5% 1.8% 5.2%
1970′s 1.6% 4.3% 5.8% 7.4% -5.4% -1.4%
1980′s 12.6% 4.6% 17.3% 5.1% 7.1% 11.6%
1990′s 15.3% 2.7% 18.1% 2.9% 12.0% 14.7%
2000′s -2.7% 1.8% -1.0% 2.5% -5.1% -3.4%
1950-2009 7.2% 3.6% 11.0% 3.8% 3.3% 7.0%

Notice the inflation the Government keeps denying is a actually 3.8% for the past 60 years and is still 2.5% despite all the talk of deflation.  That means, if your money isn’t doing SOMETHING to make at least 2.5%, you are falling behind every day.  Of course, putting your money in the market for the past 10 years hasn’t helped, without dividends that would have cost you an additional 2.7% of your cash!  Notice that in EVERY decade, our very simple combination of dividends plus call selling would have kept you above both inflation and market dips – IN THE LONG RUN.   

I emphasize IN THE LONG RUN both because it’s a great Eagles song and also because most investors are way too short-term focused and forget to look at investments as….  well, investments.   Using a simple Compound Interest Calculator, you can take $10,000, add just $5,000 a year for 30 years at the average real total return (ABOVE inflation) of 7% and that nets you $581,487.76 inflation-adjusted dollars to retire on.  This should be the base goal of any investor – simply make sure you have a conservative base to build on. 

Keep in mind that selling covered calls adds no risk other than you may, potentially miss a big move up in the stock as you have already promised to sell it for "just" (in the MSFT example) a 26% annualzied ROI but are there ANY decades where the market gained 26%?  No, of course not.  Just change that 7% figure in the calculator to 17% and watch what happens when you hit the "calculate" button - $4,898,165.34!!!  Don’t you think this is a strategy that deserves some of your attention?

Is this realistic?  Of course it is!  If people would get their head out of the short-term trading BS and concentrate more on their INVESTING, the World would be a far better place.  Few people plan for the far future but look at this chart of what 8% in a Roth IRA can do for your children’s children.  Do you need a new Mercedes or do you need to leave a family legacy?  

Hopefully, I’ve done enough to get your attention so that now we can look at some boring, slow-moving, dividend-paying stocks in a better light.  It’s all well and good to have fun playing the short-term market moves but, without a solid base in your virtual portfolio that is delivering consistent annual returns, the risks can be unacceptable.  Short-term trading can be wonderful as we can hedge our longer-term positions against market downturns or we can take advantage of aggressive up moves in the market that will be calling away our longer positions but, in both cases, the short-term trading is the fine-tuning that is meant to lock in those 8% annual returns (hopefully better!) that will make you a family legend for generations to come.  

In the grand tradition if KISS (Keep It Simple, Stupid), let’s start by looking at the Dow’s top dividend players.  We like the Dow because it’s easy to hedge with our Mattress Plays (see "The Stock Market Parachute" as well as commentary in our Strategy Section).  T, VZ, BA, HD, KFT, MRK and PFE are generally the best payers and, in establishing a long-term virtual portfolio with a dividend strategy, it’s good to keep an eye on your diversification.  Since we are selling covered calls as well, we also take into account which option sales give us the most bang for the buck and, of course, which stocks represent a good value at the current prices.  That knocks MCD, XOM and CVX off our list as they represent more of a gamble and, if we are going to gamble – we can do A LOT better than 3%

I’m not going to comment extensively on these stocks, they are Dow components and will mainly rise and fall with the index and there are thousands of articles written on each stock so let’s just say I think these should hold up well this decade and leave it at that as far as fundamentals go.  We’re using buy/writes for the spreads but you can opt NOT to sell the puts, of course – it will simply lower the returns but if you can get 17% in 17 months – that’s PLENTY: 

BA has the worst dividend (2.6%) of our Dow group but I also think they are the best long-term value.  The Dreamliner WILL get built and sold – it’s only a matter of time.  $63.16 for the stock can be knocked down $20.30 with the sale of the 2012 $62.50 calls for $11 and the $57.50 puts for $9.20 for a net entry of $42.86/50.18 and a very nice 45% if called away at $62.50, which is where they are now!  Pocketing an additional $1.68 against the net $42.86 increases the dividend to 3.9% thanks to our buy/write discount.

Good time to remind you:  We do not necessarily get called away at $62.50 - we can execute our Rawhide Strategy of "Rollin’ rollin’ rollin‘"…  Had we sold, for example, the August $60 calls and decided we did not want to get called away, we could still roll the net $4.60 caller out to 2012 and collect net $8.70.  Presumably, we would have a far lower basis and you will find this happens over the years as you build your virtual portfolio as it would only take 8 rounds of collecting net $8.70 against your BA shares to lower your net basis to zero – at which point collecting $1.68 in dividends starts seeming like a great deal!   And what do you do with the cash?  Buy more dividend-payers of course! 

This is how we "compound" our virtual portfolios over the years, we sell options and collect dividends and use them to buy more stocks that we can sell options and collect dividends against.  That brings up another thing we are not discussing here – the naked put sale!  This is the key to our Buy/Write Strategy (see "How to Buy a Stock for a 15-20% Discount") and I am 100% in favor of it but this is a post for the IRA crowd, who do not get the full benefits of selling the naked put side (and are often not allowed to) so we’re concentrating on the basic strategy – feel free to ask if you are interested in the more advanced versions.

HD has a nice 3.4% dividend while we wait for the housing market to come back (if ever).  At $28.74, selling the 2012 $30 calls for $3.30 and the $25 puts for $3.20 nets $22.24/23.62 and a call away with a $7.26 (34%) profit in 17 months.  Note that just 1% a month is a very good goal on the underlying security while the dividend of 3.3% gives you a bonus that keeps this play over the 20% annualized range.

In the interest of time I will condense several more:

  • T is nice at $26.94.  Our big worry here is that they may lose IPhone exclusivity and even rumors of that can knock them down.  Selling 2012 $25 calls for $3.50 and $22.50 puts for $2.35 nets $21.09/23.05 on the spread.  Upside is $3.91 (18.5%) plus a 6.2% dividend for a very nice 18% annualized return if all goes well.  
  • VZ at $29.84 is the opposite number to T.  They should get a nice pop if IPhones come their way and Droids are selling nicely anyway.  I am concerned about what seems to be a failure of FIOS in the end-stage roll-out.  Still, they are the phone company (well, the other one) and a 6.4% dividend is excellent.  Selling the 2012 $25 calls $5.50 and the $30 puts for $5.05 nets out to $19.29/24.65, which is still a 17% discount off the current price with a better than 50% upside and it drives the $1.90 dividend up to 10% ANNUALLY so I like the aggressive position on the put side. 
  • HD at $28.74 does very well as a hurricane play and a heavy snow play and a housing recovery play.  Selling the 2012 $30 calls for $3.30 and $25 puts for $3.20 nets $22.24/23.62.  Upside at $30 (aggressive) is a very nice 34% and the 3.3% dividend adds to the fun.
  • KFT is at exactly $30 and I can’t think of much on the horizon to worry about other than a generally slowing economy.  Selling the 2012 $30 puts and calls for $6.15 nets $23.85/26.93.  At $30 that’s a 25% profit in 17 months and a 3.9% dividend while you wait. 
  • PFE is at $16.09 and the risk here is they kill people with something plus their pipeline is weak so they may end up overpaying for a weak company and you get dilluted.  Selling 2012 $15 puts and calls for $4.80 nets $11.29/13.15.  That’s 32% at $15 plus a very nice 4.5% dividend. 
  • MRK is pretty much the same story as PFE at $35 and I just don’t find them as exciting as PFE from a spread perspective so not much point there…
  • INTC is at $18.37.  They gave poor guidance but, long-term, people buy computers.  Selling the 2012 $17.50 puts and calls for $5.65 drops the net to $12.72/15.11 for a very nice 37% if called away and that jacks the .63 dividend up to 4.9%. 

Also, a few interesting plays outside the Dow are:

 

 

IN PROGRESS

 

 

 


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  1. Phil

    Will be added when I get to it (ignore amounts, which were an example in something else):

    2,000 VLO at $16.10, selling 2012 $15 puts and calls for $6 for net $10.10.  That’s $20,200 with a potential $9,800 upside at $15 plus a tiny ($300) dividend ($10,100). 
    500 XOM at $59.80, selling 2012 $57.50 puts and calls for $16 for net $43.80.  That’s $21,900 with upside at $6,850 and a $1,125 dividend ($7,975).
    700 EXC at $40.76, selling 2012 $40 puts and calls for $9.70 for net $31.06.  That’s $21,742 with upside of $6,258 plus about $2,100 in dividend ($8,358).
     

  2. Phil

    By the way, I couldn’t get the original to update so I had to redo the post. 

  3. humvee4me

    Shadowfax:   did you go the way of yipcarl?

  4. Pharmboy

    HME might be a good one as well due to the homeowners being forced out.  Apts should do OK in this environment as long as their cash flows are good and debt restructuring has taken or is taking place.  The stock pays a dividend of $2.32, or a 4.69% yield.

  5. kwan

    Phil, why do you consider MCD a gamble? XOM and CVX I understand…

  6. Phil

    Shadow/Humvee – Wow, a guy can’t go away for a weekend without rumors starting?  8-)

    HME/Pharm – I would like to find some CRE plays, look how resiliant they’ve been! 

    MCD/Kwan – They’ve run up a lot so not too attractive.  I love them but not for $74…

  7. foolishtrader

    In the MSFT example, why do you not sell the call that is a little out of the money to give yourself some working room to not have the stock called?  Does it cut the premium too much?

  8. rexx

    Phil  – just wondering -  how does this fit in with general 35% invested in buy write suggestion?

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