Tuesday, July 28, 2020

How I Replaced Lost Dividend Income With Options Income

This article first appeared on TalkMarkets on Tuesday, 28th July, 2020.

The COVID-19 pandemic has created a challenging environment for dividend growth investors. More than 600 companies announced dividend cuts or suspensions during the second quarter of 2020, even companies with long histories of annual dividend increases.

My DivGro portfolio suffered several dividend cuts and suspensions. To date, I've experienced three cuts and three suspensions, reducing my projected annual dividend income by about $1,832. And another planned reduction will reduce my projected annual dividend income to about $1,959 by year's end.

My general approach to dividend cuts or suspensions is to close such positions. However, I've decided not to take any such action until perhaps in December, when I usually consider trades for tax-loss harvesting purposes. Instead, I've sold covered calls to replace most of the lost dividend income.

This article provides details.


Introduction


I've been a dividend growth investor since January 2013, when I founded DivGro and invested in my first stock. In 7.5 years of investing, I've collected more than $100,000 in dividend income. Every dividend dollar is reinvested, so I benefit from the compounding effect of earning dividends on stock bought with dividends.

In June 2016, I started trading options to generate extra income and to indirectly boost DivGro's dividend income. As with dividend income, selling options provided additional cash that allowed me to buy more dividend stocks. I've collected about $74,000 in options income so far.

DivGro's current projected annual dividend income (PADI) is $30,087, meaning I can expect to receive about $2,500 in dividend income every month, on average, in perpetuity. Of course, that assumes that DivGro won't suffer additional dividend cuts or suspensions!


Dividend Cuts and Suspensions



Here is a  list of dividend cuts and suspensions announced for stock positions in my DivGro portfolio:
I've also experienced a distribution cut in one of the closed-end funds I own:The following table shows the impact of these cuts and suspensions on DivGro's PADI:

 Ticker 
 Prev Div 
 New Div 
Diff.
Pay
 Freq.
No.
 Shares 
PADI
 Loss 
DIS
0.8800
0.0000
 -0.8800 
2
200
-352
ROST
0.2850
0.0000
-0.2850
4
100
-114
TJX
0.2300
0.0000
-0.2300
4
200
-184
SPG
2.1000
1.3000
-0.8000
4
80
-256
WFC
0.5100
0.1000
-0.4100
4
400
-656
ETO
0.1800
0.1425
-0.0375
12
600
-270
Total: 
 -1,832 

Additionally, on 5 July, Dominion Energy, Inc (Dannounced an agreement to sell its gas transmission storage assets to an affiliate of Berkshire Hathaway Inc. (BRK.A). Included in the announcement is a paragraph on dividend guidance. The company expects to make an additional dividend payment of 94¢ per share in September, before cutting its dividend with a December payment of approximately 62.5¢. This would represent a dividend decrease of 33.5%.

How I Deal with Dividend Cuts and Suspensions


Generally, I close a position when a company announces a dividend cut or suspension.

However, due to the COVID-19 pandemic, we find ourselves in an extraordinary situation. Many companies consider their dividend cuts or suspensions temporary, necessitated by the economic conditions that resulted from the pandemic. I'm willing to give these companies some leeway, at least until December when I usually consider trades for tax-loss harvesting purposes.

Meanwhile, the fact that the stocks have dropped towards or below my average cost basis creates opportunities to sell covered calls and to replace some of the lost dividend income:

1. DIS • PADI Loss: $352  • Options Income: $389 (or about $807 annualized)


On 23 July, I sold two January 2021, $150 covered calls on DIS for $389. Given the holding period of about six months, the net options premium of $389 would be equivalent to $803 if annualized.

If these options got exercised, I'd be very happy indeed! DIS would be trading near its 52-week high and nearly 29% above its current share price of $116.31 per share.


2. ROST • PADI Loss: $114 • Options Income: $149 (or about $309 annualized)


On 23 July, I sold one January 2021, $120 covered call on ROST for $149. Given the holding period of about six months, the net options premium of $149 would be equivalent to $309 if annualized.


If this option got exercised, it would mean ROST is trading near its 52-week high and about 41% above its current share price of $85.12 per share.


3. TJX • PADI Loss: $184 • Options Income: $309 (or about $640 annualized)


On 23 July, I sold two January 2021, $65 covered calls on TJX for $309. Given the holding period of about six months, the net options premium of $309 would be equivalent to $640 if annualized.


If these options got exercised, it would mean TJX is trading above its 52-week high and about 25% above its current share price of $52.08 per share.


4. SPG • PADI Loss: $256 • Options Income: $231 (or about $478 annualized)


On 23 July, I owned only 80 shares of SPG. To sell a covered call, you have to own at least 100 shares. So I bought 20 shares of SPG at $61.32 per share.


Subsequently, I sold one January 2021, $100 covered call on SPG for $231. Given the holding period of about six months, the net options premium of $231 would be equivalent to $478 if annualized.


If this option got exercised, it would mean SPG is trading about 61% above its current share price of $61.96 per share.


5. WFC • PADI Loss: $656 • Options Income: $219 (or about $455 annualized)


On 23 July, I sold two January 2021, $32.50 covered calls on WFC for $219. Given the holding period of about six months, the net options premium of $219 would be equivalent to $455 if annualized.


If these options got exercised, it would mean WFC is trading about 28% above its current share price of $25.49 per share.


Note that I own 400 shares of WFC, whereas I sold only two covered calls. The reason is I own 200 shares of WFC in a different brokerage account where options trading is not available.


A more appropriate comparison would be to double the annualized equivalent, to $910, which, indeed, would more than cover my PADI loss.


Here's a summary:


 Ticker 
 No.
 Shares 
 PADI
Loss
Added
Shares
Covered
Calls
Share
Count
Options
Income 
Annualized
Options
Income
DIS
200
-3522
200
389
807
ROST
100
-1141
100
149
309
TJX
200
-184
2
200
309
640
SPG
80
-256801
100
231
478
WFC
400
-656
2
200
219
455
ETO
600
-270
Total: 
 -1,832 
Total:
1,297
2,689

Concluding Remarks


In 2016, I decided to add options trading to complement DivGro's strategy of investing in dividend growth stocks. My options trading activity is focused on generating extra income. I sell covered calls on some of my DivGro positions and I sell put options on stocks I wouldn't mind adding to my DivGro portfolio.

I don't buy options and I consider myself a learner options trader.

In this article, I showed how I replaced lost dividend income by selling covered calls on the underlying positions. When annualized, the options income more than makes up for my losses in projected annual dividend income.

In December, I'll decide what to do with my positions that suffered dividend cuts or suspensions. If tax-loss harvesting turns out to be beneficial, I would have to buy back the options in order to close out these positions. Otherwise, I January when these options expire, I could consider doing another round of covered call selling.

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2 comments :

  1. Hi Ferdi, nice article and a great way to replace the dividend cuts, instead of selling immediately. Your options expire in January right, but I assume these are American style options. Does dat mean that your shares can get called away at any time (early excercise)? Of course this only happens when the share price rises above the strike price. But here is my question: how do you deal with this possibility when you don't actually want to sell the shares? Does it happen often that shares get called away 2-3 months before the expiry date?

    ReplyDelete
    Replies
    1. Hi, SamEast -- thanks for commenting!

      Yes, these are American style options that can get assigned at any time.

      In all cases (covered in this article), I'd be happy if the options are assigned. That would mean significant recovery in the underlying stocks!

      Generally, unless the share price of the underlying really runs away, there is little incentive to buy early. Remember, the options have value, too, and many holders decide to just ride out time until expiration (when they either sell the options for a profit or have them automatically be exercised).

      When exercising, a buyer will have to fork out money to buy the shares. That in itself is a bit of a deterrent.

      Delete

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