The Dividend Options Trade
May 19, 2011
- A buy/write is when you create a covered call (long stock/short call) position in a single order.
- Buy/writes can sometimes be used to capture dividends in stocks approaching ex-dividend dates.
- If you're unable to capture the dividend, you may still be able to make a very small, short-term profit.
I'm often asked if an option strategy can be used to capture dividends. The answer is yes—sometimes you can use a buy/write, a popular, relatively conservative options strategy that allows you to create a covered call (long stock/short call) position in a single order. Even when this strategy doesn't work and you don't receive the dividend, you may still be able to make a very small, short-term profit.
Previously, I've discussed a four-step process for finding quality buy/write candidates. Here, we'll explore how to use this strategy to achieve one of the two outcomes I mentioned:
- Get the dividend: You establish your position a day or two before the ex-dividend date, which allows you to become owner of record when the dividend is paid. Then you simply hold the position until assignment or expiration.
- Make a very small, short-term profit on an early assignment. You establish your position a day or two before the ex-dividend date, but if you get assigned the night before the ex-dividend date, you earn a very small profit on your trade. When the dividend pay date arrives, you will not receive the dividend.
To find stocks appropriate for this strategy, follow the steps below.
Step 1: Screen for candidates
To find potential stocks or ETFs for buy/writes, you can use a stock screener to generate a list of candidates. Clients can use Schwab's Stock Screener to select criteria.
On the left-hand side of the screen, select the drop-down arrow for Basic Criteria. Because you only want stocks that pay decent-sized dividends, check the box for Dividend Yield and Upcoming Dividends. Then, in the middle of the screen, select the box for Next 7 Days and the three boxes for 3.0% or greater dividends.
Try to avoid low-volume stocks, because illiquid stocks are likely to have illiquid options. Consider setting Average Volume (10 day) to at least 250,000 shares (select the three boxes that have greater than 250,000 shares).
Because you might end up owning these stocks for a month or so, you'll want to make every effort to hold quality stocks—those with a Schwab Equity Rating of A or B.
To filter for this, select the drop-down arrow for Analyst Ratings on the left-hand side of the screen and check the box for Schwab Equity Rating. In the middle of the screen, select A and B. Also consider reading the accompanying Schwab Equity Rating Report, which provides detailed information and can help you understand the factors that determine the Rating.
Dividend-Yielding Stock Screen
If you follow research from Credit Suisse, Ned Davis Research, Standard & Poors, Argus or Reuters, you can add them to your search criteria in the Analyst Ratings section as well. Keep in mind that the stricter the criteria, the fewer candidates you'll find.
Once you've created a screener that has the settings you want, click Save Screen to save it for future use. Then it will only take a few seconds to retrieve and run this screen each day.
Step 2: Check additional ratings
In addition, you may want to focus on stocks that also have a Market Edge Second Opinion® Weekly Rating of Long with a score of 0 or -1. You can get the Market Edge rating by clicking on the stock symbol in your output list, scrolling down the page, and selecting View Research.
Market Edge Second Opinion Weekly Rating
Security shown above is provided as an example for illustrative purposes only.
Step 3: Order entry
Most of the time you'll probably only find a handful of potential candidates. However, you'll need to set each of them up in the buy/write screen to see how the pricing will work.
Specifically, you're trying to find candidates with these characteristics:
- In-the-money buy/write,
- A month or less until expiration,
- A maximum gain large enough to cover the cost of your commissions for both establishing the position and assignment, should that occur. (This way, the worst-case scenario is a very small profit, if you get assigned immediately.)
Similar to single-leg option or stock orders, buy/writes have both a bid and an ask price, and you usually don't have to pay the market asking price to get an execution. Consider entering a limit order between the bid and ask price, as you would on a single-leg order.
To help maximize your chances of getting an execution at a favorable price, consider entering the order slightly on the high side of the midpoint. Active Trader clients can use our new trading platform, StreetSmart Edge, which displays the midpoint for you.
Take a look at the 100-share example below. This buy/write has a midpoint price of $29.67. If an order was entered at a debit of $29.70, the likelihood of it getting filled is pretty good.
Entering a Buy/Write Order
Security shown above is provided as an example for illustrative purposes only.
Source: StreetSmart Edge.
The trade being considered is a buy/write where the covered call is in-the-money by $1.59 (the strike price is 30 and the bid price on the stock is $31.59), with an expiration date about four weeks away. The stock research page shows that this stock pays a quarterly dividend of $0.30 (about 3.8% annual yield) and goes ex-dividend tomorrow.
Since this option is in-the-money by $1.59 but has a bid price of $1.80, there will be a loss of time value of $0.21 if the owner of the call decides to exercise to capture the $0.30 dividend; so you may or may not get assigned immediately.
If you're assigned immediately
With a displayed maximum gain of $30 (which occurs if you're assigned immediately) the profit potential is enough to offset the commission charges of $18.65 ($8.95 for the stock purchase, $0.75 for the sale of the covered call and $8.95 for the stock sale). So the net gain would be $11.35 ($30 - $18.65) but you would not be entitled to the dividend.
In addition, your risk is limited by the relatively short time you'd own the stock before ex-dividend date. Ideally you want to focus only on those stocks whose ex-dividend date is tomorrow, but sometimes I've successfully used this strategy on stocks whose ex-dividend date is the day after tomorrow, but only if the assigned rate of return (Max Gain) is high enough to justify the risk.
Important note: Commission costs are a very important consideration in this strategy—the higher the maximum gain shown in the trading window, the better. If the maximum gain at your selected limit price is insufficient to cover the total commission costs of immediate assignment, you should reconsider making the trade.
If you're not assigned immediately
If you aren't assigned immediately, then early assignment becomes far less likely. Your gain, if assigned at expiration, would be $30 (assignment price of $30 per share - original cost of $29.70) and you'd also be entitled to the $30 dividend, for a total profit of $41.35 ($60 - $18.65 commissions) per 100 shares.
Keep in mind, however, that if you establish this position at $29.70, your downside protection is equal to the value of the option (approximately $1.80 per share) plus the amount of the dividend ($0.30 per share). So if you're not immediately assigned and the stock declines by more than $2.10 (about -6.6%) at expiration, you'll lose money.
For larger orders, the option commission of $0.75 per contract would increase proportionately with an increase in the number of contracts, but the stock commissions would remain at $8.95 regardless of the number of shares.
Watch for the ex-dividend date
A variety of related option strategies are often employed by institutional and retail investors alike, and the larger the dividend, the greater the activity. So next time you see unusually high options volume on a particular stock, check to see if tomorrow is the ex-dividend date.
I hope you find this potential dividend-capture strategy as appealing as I have. For more information please contact a Schwab Trading Specialist at 800-435-9050.
Good luck and good trading.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options."
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