Stock Option Trading News

Puts with a dividend twist

Selling put options is one of the more popular income generating strategies used by options-savvy investors. Generally, the strategy involves selling an Out of the Money (OTM) put on a stock on which you are bullish. This means the price of the underlying stock is higher than the strike price of the put option. The option may be 5-10% OTM at the time it is written.

A put writer, who is selling naked puts, expects the option to expire worthless at expiration. And that’s exactly what will happen as long as the stock does not drop in value below the strike price of the option. In this case, an investor keeps the premium received for writing the put, without ever owning the stock. The amount the option is OTM provides downside protection. If the option is 10% OTM, the price of the underlying stock can fall 10% and the premium can be kept and full profit realized. As an example:

IBM stock is $82.03
Feb 75P is $.40 due to expire 2/18/06
% OTM is 8.6% (the stock can fall this amount before a loss is incurred)

Altria Group stock is $74.65 (MO)
Feb 70P is $.90 due to expire 2/18/06
% OTM is 6.2% (the stock can fall this amount before a loss in incurred)

In the first case, the $.40 put premium will decline to zero as long as the price of IBM stays under $75 per share by February 18th. Therefore, IBM can decline 8.6% and the investor will still be able to keep the premium and realize a .4% profit in 50 days.

The twist comes from an investor who took a different approach to naked puts. He forced assignment of the put (the obligation to acquire the stock), then being in position to collect the dividend from the stock. Once the stock is acquired, a covered call is written against the stock owned. This methodology creates three different sources of income:

1. Naked put premium
2. Dividend income on the stock
3. Covered call premium

If the timing on entering these positions is done carefully, all three forms of income can be acquired in a month or two, greatly increasing an investor’s option income.

To increase the probability of a naked put being assigned, it should almost always be written In the Money (ITM) or At the Money (ATM) as opposed to OTM. By writing the put ITM, the probability of assignment of the stock and your ability to collect the dividend is enhanced. Using this method, you would write the put with an expiration and assignment just before the dividend is declared.

By writing the put ITM, there is an interesting play if the stock were to rise considerably. Since the option was ITM, the premium was very high. If the stock were to rise above the strike price the premium would drop considerably and, possibly, expire worthless. The downside of this scenario is that the stock is not assigned and, therefore, the dividend is not available. However, since the premium was so large for the ITM put, the overall return will be very high, and generally higher than if all of the income was acquired as originally planned. This is one case where writing options does not limit severely the upside potential of the stock. As an example:

Assume Altria Group at $74.65 (MO)
06 Feb 75 Put @ 2.35
ITM .5%

If the stock moves over $75, the option price will drift toward zero and eventually expire worthless. This will happen in 48 days since the Feb expiration date is on 2/18. The return on just the naked put would be:

Return = 2.35 / 75 = 3.13% in 46 days or 25% annualized

Putting it all together with an example using the Altria as the stock:

Data for the example with Altria Group (MO):
Dividend ex-date: 12/23/05
Yield: 4.27% / year
Payable: 1/10/06 in amount of $.80 per share
Stock Price on Thursday, 12/1/05 @ $73 1/4 (MO)
Option price Dec 75 Put @ 2.00 and expiration date 12/16/05 (16 days out)

Steps in implementing this strategy for Altria:

1. Search for a stock with an ex-dividend date after the expiration for the month.
2. Write a put that is ITM to force assignment at expiration (12/16/05); you would receive $2.00 per share or $200 for one hundred shares.
3. In this case, the strategy would have not been completed since the stock rose sharply on December 15th and stayed over 75 past the expiration date.
4. On 12/16/05 the option expired worthless and the entire $2.00 was kept for a return of 2/75 or 2.7% in 16 days or 60% annualized.

Data for an example with Merck & Co (MRK):

Dividend ex-date: 11/30/05
Yield: 4.64% / year
Payable: 1/3/06 in amount of $.38 per share
Stock price on Thursday, 11/3/05 @ $29.50 (MRK)
Options price Nov 30 Put @ .65 and expiration date 11/18/05 (15 days out)
Options price Dec 30 Call @ .70 on 11/28/05 with stock at $30 with an expiration date of 12/18

Steps in implementing this strategy for Merck:

1. Search for a stock with an ex-dividend date after the expiration for the month.
2. Write a put that is ITM to force assignment at expiration (11/18/05); you would receive $.65 per share or $65 for each one hundred shares.
3. In this case the stock closed at $30 and was assigned. We had to purchase 100 shares at $30 for $3,000. A covered call for the month of December was written for $.70
4. On 11/30/05 MRK went ex-dividend and $.38 / share was locked in for payment.
5. On 12/18/05 MRK was still at $30 and the shares we owned were called away or assigned.

In summary, the results for our 100 shares of MRK were:

Income from the Nov 30 Put = $65.00
Income from the Dec 30 Call = $70.00
Income from Dividend 1/3/06 = $38.00
Total = $173 in about 43 days

We have collected income from 3 sources totaling $173:

Return = 173 / 3,000 = 5.77% in 43 days

As you can see this strategy is a neutral to bullish strategy. It works best for the rising stock with a high dividend. The worst-case scenario is when a stock declines. If it declines it has an even higher probability of being assigned. However, the higher put premium will not make up for the decline. The stock will be acquired for the higher strike price and the decline will not be compensated for since the time premium is very low on the ITM put. Once the stock is acquired you can start writing covered calls and slowly make up for any losses. At some point, however, you need to face the fact that the stock may not have been a good pick and simply exit with a loss. Another more advanced technique for protecting this position is to form a collar spread.

The PowerOptions site has the capability to search the entire universe of options to find optionable stocks that fit the criteria of:

* An underlying stock with an option expiring in only 30 or 60 days
* A naked put return over a certain value
* A put that is ITM by a specified amount
* A stock with a bullish broker recommendation and/or technically trending up
* A stock with a dividend over a specified value
* A dividend date that is within 30 and 60 days

Depending on your level of service you can scan the entire market every 20 minutes-or in real time-to find these kinds of opportunities. Screening criteria, such as listed above, can be named and re-run every day to find puts with a dividend twist.

Click for a glossary of investing terms.

Good fortune!

Technorati Tags: Selling Put Options, Covered Call, Option Income, Investing Terms


  1. Loren Gordon

    Interesting. Of course, selling a naked put *is*, for all intents and purposes, a covered call. Just look up the synthetics. So if you’re selling an ITM put close to the market, you may as well buy the stock and sell the same call. There are probably margin requirement differences, but if the intent is to buy the stock at the put strike eventually, that’s not much of an issue.

    In other words, the return would be the same, and you’d still capture the dividend, if you just started with the covered call instead of the put.


  2. Ernie Zerenner

    Hi Loren

    I understand your comment that the naked put strategy is essentially a covered call. However, these ITM cases of a call vs a put have some fundamental differences. If either a call or a put is written so they were ITM and both had the same time premium, they would have the same return if assigned. But that is where the comparison ends. If the stock goes up over the strike price of the put, it will not be assigned and the return will be very high because of the intrinsic value captured. The call will give the same return as if the stock price did not change. Just the opposite is the case if the stock declines. Therefore, the risk reward positioning is different between the two cases. The ITM call is positioned for downside protection and the ITM put is positioned for upside speculative gains.

  3. Loren Gordon

    Well, yes. Comparing an ITM put to an ITM call is obviously going to give you a different risk/reward profile. So to duplicate the naked put strategy described in the article with a covered call strategry, you would simply sell the call at the same strike as the put. I guess I didn’t mention the strike explicitly. The sold put is ITM, the sold call is OTM.

    So, case 1, the stock stays between breakeven and the strike. The naked put is assigned (because it was ITM). The sold call would expire worthless. The extra premium from selling the ITM put is gone because the purchase price at expiration is the strike, and the stock price at expiration is lower than the strike. In either case, you own the stock after expiration, and the effective purchase price should be very very close (neglecting some kind of arbitrage opportunity).

    Case 2, the stock rises above the strike. The naked put expires worthless, and the call is assigned. The difference in the premium between the ITM put and the OTM call is made up in the rise of the stock price (since it was purchased at a lower price at the same time the call was sold).

    Case 3, the stock falls below the breakeven. The put is assigned, and the call expires worthless. This is similar to the first case, but instead of making a little money, you have to take a loss or continue managing the position so that you can exit with a profit later on.

    Unless I simply am missing some understanding of how these options and the markets work, the two approaches are the same. I’m not trying to argue whether it’s better to trade covered calls or naked puts; I’m saying that they are the same thing.


  4. Jdobbs

    Actually if you sell short a put contract that crosses the dividend day, you actually collect the dividend upfront since the dividend is priced into the put premium.

    Just like selling a covered call on a stock that crosses the dividend ex day will have the dividend subtracted from the premium.

  5. baruch

    there is one important aspect you are missing. Puts are insurance policies making them expensive in bear markets or eve down days so selling puts can be more lucrative and if you want to own the stock anyways then it’s a win win scenario

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