Adding a Buy-Write to Your Best Dividend-Paying Stock
The S&P 500 is essentially unchanged since Thanksgiving 2014!
While there have been short periods of volatility (in just the last two weeks, it’s been down 5% then up 5%!), the S&P 500 can’t seem to break through the 2,000–2,100 range.
With the market stuck in this range, and banks and bonds offering virtually zero yield, how can investors get ahead?
One strategy that has been working well for investors is to buy the best dividend-paying stocks and apply an options strategy called a buy-write (also known as a covered call).
Buy-writes offer a way to supercharge your returns and handily beat the yields offered by your bank’s money market accounts.
Many very savvy Cabot subscribers have combined dividend-paying stocks and buy-writes to create extra yield in their portfolios. They choose their stocks from Chloe Lutts Jensen’s Cabot Dividend Investor and apply the yield-boosting buy-write strategy from my Cabot Options Trader or Cabot Options Trader Pro.
Here’s an illustration of how these investors have been able to soundly beat the choppy market environment.
In early April, Chloe recommended the purchase of Wynn Resorts (WYNN) when it was trading at 93. After Chloe’s buy recommendation, WYNN exploded higher, trading over 100, but has pulled back post-Brexit. Now the stock is virtually unchanged since her recommendation, essentially trading in line with the choppy market.
However, Cabot subscribers who own the stock will be paid the company’s quarterly dividend (which is expected to be $0.50 per share in early August). The company projects a dividend yield of approximately 2%.
While 2% is nice, by combining a buy-write options strategy with a dividend-paying stock, investors can seriously juice their returns.
Before getting to the big returns possible with such a strategy, I’ll first explain a buy-write.
A buy-write, also known as a covered call, is a strategy in which the trader holds a long position in a stock and writes (sells) a call option on the same stock in an attempt to generate income.
For every 100 shares of stock you own, you can sell one call. If you own 500 shares of stock, you can sell five calls.
A buy-write is a VERY conservative strategy. It requires no margin and is a great way to create yield and lower your cost basis on a stock position. The only downside is that you give up the potential for explosive upside gains.
So let’s say I bought 100 shares of WYNN at 93 when Chloe recommended the stock in early April. Because I was executing a buy-write at the same time I bought the stock, I would also sell one WYNN September 115 Call for $4.50 per share.
When I sold the one call at $4.50, I actually collected $450 because each call represents the equivalent of 100 shares. So for every 100 shares I purchased, I can sell one call.
($4.50 per call x 100 shares = $450)
So in April, I theoretically bought 100 shares at 93, and sold one September 115 call for $4.50. Let’s take a look at the various scenarios that could play out in this trade.
Three Scenarios Based on the Dividend Stock’s Action
Scenario 1: WYNN shares trade flat for the next several months. At that point, I will have collected the dividend of $0.50 per share in early August. In addition, because WYNN is still trading at 93, the September 115 Call that I sold will expire worthless as the owner of the call will not exercise his right to buy the stock from me at 115, and I will collect the $450 credit. Combined, the dividend payment of $50 per 100 shares, plus the $450 per call sold, yields $500 (5.37%) for holding the position for six months.
Scenario 2: WYNN shares fall to 88. At that point, I will have collected the dividend of $0.50 per share in early August. In addition, the September 115 Call that I sold will expire worthless and I will collect the $450 credit. However, because the stock has fallen $5, my net position is breakeven because the $500 I lost on the stock is offset by the $500 I received from the dividend and the call sale credit.
Scenario 3: WYNN shares trade above 115 on September expiration (9/16). At that point, my 100 shares will have appreciated 22 points ($2,200), plus I’d collect the $0.50 per share dividend and $450 for the sale of the call for a total profit of $2,700. There is a downside to this scenario: the owner of the call has the right to buy the stock from me at 115. Assuming he does, I would no longer own a position in WYNN (but I would still have a profit of $2,700).
It’s Easy to Create More Yield Every Month
Here is the graph of profit and loss on the position at various stock prices:
I want to point out a couple of items on the graph.
The call sale has lowered my breakeven from the original purchase price of 93 to 88. But if WYNN closes below 88 on September 16 (the option’s expiration), I would lose $100 for every point the stock falls, just like every stock position.
Also note that my profit would stop at 115. Above 115, my profit is capped at $2,700 because I would no longer own the stock. However, I would still gain a profit of 29% in just six months.
If you have never traded buy-writes/covered calls before, I recommend that you first choose a stock in which you own more than 100 shares. For example, if you own 1,000 shares of General Electric, I recommend that you only sell one or two calls in order to learn how the strategy works.
Or you can subscribe to Cabot Options Trader/Cabot Options Trader Pro where we typically execute a couple of buy-writes every couple of months.
By adding this strategy to your investing arsenal, you can create more yield every month for your portfolio and soundly beat the performance of the S&P 500 in a choppy trading environment.