Retirees seek reasonable, consistent yield without a threat to the nest egg. I am continuing my series on my favorite method for achieving this objective. While this is not investment advice for any specific reader, I hope that some will find it both interesting and useful.

Introduction

The program, simply described, consists of buying a good dividend stock and selling a call against the position. While there are many dividend programs and many covered call programs, there is a powerful synergy from putting them together. There is also skill in choosing suitable stocks and the right call to sell. Beyond the initial trade, there are many questions about how to handle the movement in the underlying stocks. I thank everyone who has joined in the comments. There are many good ideas for new themes and examples for future posts.

While I cannot explain everything in a single post, the entire series will provide a comprehensive look. Every trade is something we actually made for client accounts. Here is a review of the past articles, the stock cited, the issue illustrated, and a comment on where we stand.

Toyota Motors: Is it Better to Sell a Put?

In my prior installments, several astute readers have suggested selling a cash-secured put instead of buying stock and writing a call. I promised to take up this topic, and a recent trade provides a good example.

Let’s look at the opportunity in Toyota Motors (TM ).

Review: Choosing a Suitable Stock

I discuss this more fully in the IBM article (check table above). The best stocks for this approach have the following characteristics:

• A reasonable dividend – 2.5% or more is fine.
• A good balance sheet.
• A reasonable payout ratio, providing confidence that the dividend can be maintained.

• Limited downside risk.

  • A cheap stock on a P/E basis.
  • Evidence of technical support.

We do not care about the immediate chances for an upside move. We do not care about the “organic” earnings growth versus share buybacks. We do not care if the stock is out of favor or boring.

We seek a safe platform for selling calls. Wherever someone sees a “value trap,” we see a candidate for this program.

Let’s start with the dividend history for Toyota. While it is not a “dividend champion” it has stabilized at a solid level, maintained for several years.

For valuation, I use FAST Graphs to verify that the price is attractive. It looks quite good right now and will be even better if the expected earnings rebound is accomplished.

The Trade

This investment included two elements, both executed recently for new clients:

• We purchased stock at $120.80.
• We sold the JAN 125 C for $1.20.
• There is no scheduled dividend before the call expires.

Here is the chart.

Despite the market pressure, we are down only slightly on the stock price. Our time period is about six weeks. If the call expires worthless, it will represent an annualized gain of about 9%. In exchange for a slightly lower than usual return on the call sale, we have a potential upside of $4.20 on the stock. If the stock is called away at that price, we’ll have an annualized return on the stock portion of over 30%.

Selling Puts as an Alternative

Selling a put can be selected instead of buying stock and selling a call. If the strike price is the same, it is a theoretically equivalent position. This would mean selling the JAN 125 put, an in-the-money option. The put price was about 5.40, roughly equivalent to the call premium plus the potential appreciation. If the stock is lower than 125 at expiration, we are compelled to buy the stock at 125. This subtracts from our original 5.40 premium.

Most put sellers prefer to sell an out-of-the-money put. Their idea is to establish a new position at an attractive price if the stock declines. An example, in this case, would be the JAN 120, which was trading at about 2.40. In this case, you collect the 2.40 premium if the stock remains above 120. If it is lower at expiration, you must buy it at 120, but the effective entry price is $2.40 lower at 117.60.

The advantage of the first choice is that you can set a theoretically identical position with a single trade. The second choice is attractive if you are willing to own the stock, but only if the entry price is lower.

Why Most Investors Should Prefer the Covered Call

There are several issues with selling puts.

• It is not allowed in some accounts – IRA’s for example. In other accounts, you need to establish enough experience to qualify for this trade.
• You can get in trouble if you do not maintain enough cash to buy the stock at the strike price. Historically, many have been tempted to collect the “free money” from put sales without really planning to purchase stock.
• In our approach, we find the stock attractive at the current price but are willing to sell at the strike. This is not really replicated by the put sale.
• If there is a dividend (not relevant in this particular case) you will not collect it. Theoretically, the put price will reflect the amount of the dividend.
• Infrequently, but most important, there can be a real disaster. Clearing firms and brokerages make unusual margin decisions in stressful times. In the 1987 crash, for example, a trader was short a put at the 20 strike. The stock declined to 2. The put, which had no real market, was trading at the impossible price of 21.50. The clearing firm bought at this price, locking in a huge and impossible loss for the trader. I am picking one example out of many. If your position is deemed to be too risky, the margin department will act.

Key Lessons

1. Selling a put is an alternative to buying stock and selling a call. In most cases the advantage of this approach is slim.
2. If selling the put, it is important to plan on owning the stock at a price you are willing to pay and being able to sell at a price of your choice.
3. Less-experienced investors risk major losses in the rare cases of a big market decline. A savvy and experienced friend agreed with my warning about trying to get too sophisticated with this strategy. It is suitable only if you are constantly and carefully watching positions – and know when to act.

Putting It All Together

One advantage of this program in times of market stress is that the checks keep coming. Of our targeted portfolio yield of 9%, 4/5 of it comes from selling calls. Most people can take 5% yield on the original investment and reinvest the rest. The yield payout comes from the dividends and call sales, not from selling our stocks. In that sense, it is like a regular dividend program. An advantage is that if the underlying stocks decline, the reinvested yield increases your position size. You are “buying low.” When stocks are sold (closing above the target price) you are “selling high.”

Can It Work for You?

The TM idea is still a good one, as are some of the past choices. Experience is good, but you should start small while you get the hang of this method.