Rounding third base. Today is the final Friday of September and Q3. The home team keeps putting up wins, as the S&P 500 total returns look like they’ll touch 9%.
The final accounting period of the year is signaled not only by changing leaves, but with a spate of dividend announcements. SPY went ex-dividend last week - though you’ll have to wait until Halloween to get your cash.
For many different investment objectives, these cash flows matter. First of all, you need to make sure to include that in your total return objective.
If you’re trading SPX because you like the tax benefits or cash settlement (I sure do), it's important to note the difference in total returns. SPY only yields 1.22% a year, but that needs to be included in a forward calculation along with rates. Whether your brokerage account with VOO/SPY goes up by 8% is different than if the SPX does.
Quarterly is the most common, but many vehicles are also required to make monthly distributions. N.B. These vehicles tend to be built with futures and swaps to mimic leveraged/inverse results, or systematically apply options strategies - they’re not meant for long term holding so please don’t annualize or extrapolate their value.
As we get closer and closer to a dividend date, it becomes a more significant valuation component for options.
There are a lot of ways to think about the cost of carry, but I like to boil it down to dollars and cents, and create a forward value. Rates add up over time, but relatively big amounts in short time periods will create increasing differences between spot and forward values.
Right before a dividend you see some funky things. Starwood properties is scheduled to pay out $0.48 on a $20.71 stock next week. This makes the Oct $21 call worth only a dime and the puts worth $0.87. These options shouldn’t be priced based on a $20.71 expiry price -even though thats imminent - but on the stock minus the dividend paid.
Today in Fifty Ways to Trade an Option, we’ll dig into how to trade covered calls in dividend stocks.
Selection of the underlying is of course primo importance, but understanding forward pricing is key for strike picking. There are plenty of good dividend paying stocks out there. Picking the right one is a delicate balance of fundamental analysis and risk tolerance. I like to group dividend payers into four broad categories. Fortunately you only need to focus on two of them.
While there are plenty of good companies that don’t pay anything at all (AMZN), there are also many companies that only pay them incidental to their business (META). Not just because stock is a rocket ship, but $2/year is relatively meaningless bps for the typical stock holder. Invest and trade options around these names for other reasons.
The other category you can broadly ignore, is the derivative ETF category. If you want a thorough explanation - look no further than “derivative income bumhunting” by Kris Abdelmessih. Whether it’s covered calls or puts, and no matter the underlying, stay the hell away. You will get gouged by the systematic naivete of these strategies and pay hefty fees to be dumb liquidity.
Now that the chaff has been separated, the first category of companies to screen for are “regular” businesses that pay dividends as part of their ownership value proposition. Verizon, Philip Morris. AT&T. The catch here is also the stock price. BP and Ford also have nice looking dividend yields but plummeting equity valuations.
Use the Screener at TheTape to filter through high dividend paying stocks, and compare other indicators. Look at ATMVol to get an indication of the holding experience, or Bollinger bands to see where the trend has gone. COVC30 gives a stable indicator of expected call premium from the 30 day, 30 delta call.
If that 16% yield on the Screener in AGNC caught your attention, you might be interested in the fourth group of dividend paying companies. While not to shade them as “irregular” businesses, companies like AGNC or Starwood Properties are structured as REITs that are mandated to pay out high percentages of their income. MLPs like ET also fit the bill here. But not SPACs, definitely not SPACs.
Underlying selection will be the most important decision you make in trading a covered call. This is a long delta strategy. To make money, you need to buy names that will be stable or go up, and not focus on the overlay premium. (That is financial advice.)
Companies pay distributions because their owners prefer to have liquidity in their pockets rather than in the business’ projects. That caps the right tail of potential future value. So does selling a call. That’s a good reason why overlays on dividend stocks are a desirable portfolio.
Getting into the options pricing, the keys here for dividends are magnitude and timing. If there’s no dividend between now and expiration, continue on as you would with any other name.
While AGNC’s yield is bigger, the dividend amount is dollars smaller. A dozen dimes adds up for a $10 stock, you’re still within the bounds of a $.50 strike interval. Past 60 days and it’s dollar intervals.
Currently ET presents a good example of strike picking questions. With $0.50 pricing intervals and a $0.30 dividend, the forward value will matter if you’re rolling out ~30 days. Previously they’d paid around the first week in November, but last year was Oct 27th.
Markets are fairly liquid for the front months, but go out to Nov 8th and there are gaping holes most likely due to dividend uncertainty. The fact that no one is even offering 30/40 delta puts for less than a $1 is wild.
That should make you skeptical about what calls you want to sell. Here we have a tough balance between not wanting to use short term trading for a longer dividend focused underlying. But if the market doesn’t know when this dividend is, that’s not worth the risk.
Fortunately the Oct 25th markets look pretty confident there’s no dividend. We have a tight forward value around $16 - calls are a few pennies higher than puts and stock is trading at $16.
The inclusion of dividends adds a distinct and often desirable dimension of cash flow to a portfolio. However it’s important to pay attention to the ex-dividend dates when using covered calls, as you risk mispricing the underlying level.