Dividend Stocks and Options
For investors in the stock market today, one good way to safely target dividend income is through a covered put dividend-capture strategy.
A covered put dividend-capture strategy involves using an option called a put to capture a dividend while also mitigating the loss experienced from the fall in stock price.
The key to this strategy is the put option. A put option is an instrument that gives the buyer the right, but not the obligation, to sell a stock at a predetermined price and within a specific time. For example, if you have a stock with a price of $50 and you are concerned about it falling in value, you could buy a put that would protect you from any downside risk.
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How Does a Dividend-Capture Strategy Work?
Let’s imagine you own 100 shares in a stock with a price of $50 per share. You recently bought the stock because it is getting ready to pay out a $0.50 per share dividend in three days. Stock prices usually fall on the ex-dividend date, in large part because of the automatic price adjustment that occurs on ex-dividend dates. Once the investor captures that dividend, they can sell the put and the stock itself on the ex-dividend date.
Hedging Risk in a Captured Dividend Strategy
Investors trying to pursue a dividend-capture strategy need to protect themselves against the risk of the stock price falling on the ex-dividend date.
In order to hedge against this risk and still capture the dividend, you buy a put option where the delta would be high on the day the stock price drops. A key point is this last part of the strategy – an option with a high delta.
Delta is the ratio of the change in the price of an asset to the change in the price of the derivative. For puts, deltas range from -1.0 to 0.0. For instance, if a stock’s put has a delta of -0.7 then that means a $1 increase in stock price will decrease put value by $0.70. Thus, a put with a high delta is one where its value is only significantly influenced by the fall in price of the stock.
In practice, this means an option that has little time value versus its intrinsic value. The time value of the option is the option’s value in excess of the difference between the stock price and the option’s strike price. If the stock is trading at $48.40 and the put option’s strike price is $50 then the intrinsic value is $1.60 ( $50 – $48.40 = $1.60 ). If the put option sells for $2 then the time value is $0.40 ( $2 – $1.60 = $0.40 ).
Investors looking for high-delta puts should start by looking at short-dated put options, which have less time remaining and low enough volatility that a dividend-related price decline is a consideration.
Once the investor has found an attractive option to complement the $50 stock, it’s time to put the strategy into motion. On the ex-dividend date of the $0.50 dividend, the investor has three factors that will influence his or her profitability:
- The $0.50 dividend – a fixed and unchanging benefit to the investor.
- The decline in the stock price – this could range from no change in the stock price to a decline in price equal to the full $0.50 dividend – assuming no other negative influences on stock price of course.
- The increase in value of the put option, which is equal to the put’s delta multiplied by the price decline. A delta of -0.8, for instance, leads to a rise in the value of the put option by $0.40 for a $0.50 decline in stock price ( -$0.50 * -0.8 = $0.40 ).
The increase input value at least partially offsets the fall in the price of the stock. The investor is left with the dividend but little other risk.
Looking for more information about investing and using options? Check out this article that explores a strategy to generate weekly income using weekly options.
Exiting the Investment
Once the investor has reached the ex-dividend date and is entitled to the dividend, the investor can exit the position. Having reached the ex-dividend date, the investor will receive the dividend, so the only remaining parts are the put option and the stock itself.
The investor should sell the stock and the put itself. Ideally, the profit from the rise in the value of the put option should be equal to the fall in value of the stock. Owning the stock and put for the long term would expose one to significant risk that is not part of the dividend-capture effort so it does not make sense to hold the stock beyond the ex-dividend date. As you are a dividend-capture strategist, you wouldn’t want to own the position for a long time.
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The Bottom Line
While a strategy this complicated might not be a good fit for everyone, it is an attractive option for investors who are interested in a low-risk way to capture dividends. The key to successfully implementing this strategy is finding a dividend large enough to justify the trading cost for both the put and the stock and, of course, finding a high-delta put.
A dividend-capture strategy can also be pursued using calls, though that is outside the scope of this article. Look for more information about this approach in a future piece.
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