With interest rates at zero and Treasury yields near record lows, the search for yield is increasingly becoming a Fool's errand. No wonder dividend stocks have come back in fashion. Still, the best companies rarely sport a dividend that exceeds 4% or 5%. But I know a strategy that will enable you to double the yield on a stock you own -- without putting up a single dollar.
Options: What you may have heard
Most investors associate options with frightening notions such as leverage, high risk, volatility and complexity – and those are just the polite terms. Smart investors, however, know that options are simply another tool in their toolkit. You can execute low-risk strategies with options to generate extra income in your stock portfolio. But to understand the strategy, we'll need to go over some basics first.
Options 101: Put options
"Put" options give the buyer the right -- but not the obligation -- to sell a stock at a predetermined price (the "strike price," or just "strike") on or before a certain date. If the put buyer exercises that right, the person who sold them the put has the obligation to buy the stock at that price. How does the put buyer decide whether or not to exercise the put? It all comes down to the price at which the stock is trading when the put expires.
Here's an example: You sell a put option on Google's stock with a strike of $500, which expires in January 2012. Come January, here's how things will shake out:
|
Scenario |
Outcome |
Put Buyer |
You (Put Seller) |
|---|---|---|---|
| Google's stock price is above $500 strike price |
The put has no value: Why sell the stock at a price below market? Put buyer doesn't exercise the put. | Has lost the premium paid for the put. | Keep the amount you received for the put. |
| Google's stock price is below $500 strike price |
The put has value, since it allows you to sell the stock at a price above the market. Put buyer exercises the put. | Sells shares of Google to the put seller for $500. | Own shares of Google at a cost basis of $500 minus the amount received for the put |
Selling puts for income
In the opening paragraph, I said I would show you how to double the yield on a stock you own. By selling a put on the stock, you'll receive the price paid for the put -- also known as the premium -- upfront. If you choose the right strike, that premium represents a yield that is equal to the dividend yield on the stock. Here's how it would work in practice for seven blue-chip stocks:
|
Stock |
Dividend Yield |
You Sell |
Enhanced Yield* |
|---|---|---|---|
| Abbott Laboratories (NYSE: ABT) | 3.7% | Jan 2012 $45 Put for $1.26 | 7.9% |
| Altria (NYSE: MO) | 5.6% | Dec 2011 $25 Put for $1.00 | 13.1% |
| Bristol Myers Squibb (NYSE: BMY) | 4.8% | Dec 2011 $25 Put for $0.92 | 11.5% |
| General Electric (NYSE: GE) | 3.2% | Dec 2011 $15 Put for $0.36 | 7.2% |
| Intel (Nasdaq: INTC) | 3.4% | Jan 2012 $17.50 Put for $0.56 | 7.9% |
| Nucor (NYSE: NUE) | 3.7% | Jan 2012 $30 Put for $0.84 | 7.3% |
| Philip Morris International (NYSE: PM) | 3.8% | Dec 2011 $57.50 Put for $1.22 | 7.4% |
*Annualized. Source: Yahoo! Finance and author's calculations.
The alternative scenario: Filling out your stock position
If the put isn't exercised, you will have effectively doubled the yield on your stock. But what if the put is exercised? In that case, you'll be obligated to buy the stock. Consequently, you should only sell puts when you want to add to (or begin) your position, but not at current prices. The stocks in our table don't look expensive right now on the basis of their earnings multiples, but selling a put at a strike below the current share price will give you an extra margin of safety. Remember, the premium you receive for the put will further lower your cost basis.
The table below shows your cost basis on the stocks if the puts are exercised:
|
Stock |
Cost Basis on Stock if Put Is Exercised |
Discount to the Current Market Price* |
|---|---|---|
| Abbott Laboratories |
$43.74 |
15% |
| Altria |
$24.00 |
10% |
| Bristol Myers Squibb |
$24.08 |
12% |
| General Electric |
$14.64 |
21% |
| Intel |
$16.94 |
21% |
| Nucor |
$29.16 |
27% |
| Philip Morris International |
$55.78 |
17% |
Let's sum things up: Selling a put on a stock you own will enable you to either double the dividend you receive on the stock, or add to your stock position at a discount to the current price. For the right stock(s) in your portfolio, that's a win/win proposition.
That's just the type of low-risk opportunity Motley Fool Options advisor Jeff Fischer and associate advisor Jim Gillies like to identify, in order to generate extra income for a stock portfolio while reducing its volatility. Of the 30 completed trades they have recommended, they've closed 29 at a profit, for an astonishing success rate of 97%!
A risk-free next step to options success
If you'd like to find out how to put option strategies to work in your portfolio, simply add your email address below, and you'll receive -- at no cost or obligation to you -- the Options Insider playbook, plus access to three videos in which Jeff and Jim discuss option strategies. You'll also get an invitation to a live, interactive Q&A session in which they will be available to answer your questions, along with the entire Options team. What's your downside to finding out more about these strategies?
