Since Wednesday was PI day (3.14), I thought I might update my PI trade article, says Dave Landry, f...
Dobosz on Options, Dividends & Income
09/26/2016 10:00 am EST
Options are not only for gamblers; indeed, John Dobosz uses a variety of options-based strategies to generate income. Here, the editor of Forbes Premium Income Report walks us through several techniques, including boosting returns with dividends and options.
Steve Halpern: Our guest today is John Dobosz, editor of the specialized advisory service, Forbes Premium Income Report. How are you doing today, John?
John Dobosz: I'm doing great, Steven, thank you. How are you?
Steve Halpern: Very good. Thanks for taking the time. Now most people use stock options as very risky vehicles for traders and speculators. However, you use options as part of a conservative income-generating strategy. Could you give a brief overview of how this procedure works?
John Dobosz: Sure. Options can be risky. If you are an owner of options, you suffer from the fact that they do not live on forever. They only go on and have existence until the expiration. And, you know, if you buy a call option, the call option entitles the holder to buy a stock at a certain price before the expiration, but if the stock is never above that price, that call option will expire worthless.
That's where we come in. We are sellers of options; we are not buyers of options. So, you can use them in tandem with an equity-investing strategy to produce income on stocks that you already own or stocks that you wouldn't mind owning at a certain price. The other type of an option is a put option.
A put entitles the holder to sell a stock at a certain price before a specified date, the expiration date, at the strike price. So, we've turned that around, not being the owner of the put but the seller of the put, we would say, for example, if Intel (INTC) is at $36 right now, we wouldn't mind owning it at $35 or lower.
So, we could sell a $35 Intel call option that expires in about 30 days or 45 days, or up to two months generally is what I use for a timeframe, and we would earn money today for taking on that obligation in the future of possibly having to buy Intel at $35 if it closes below that, that expiration.
But our cost basis would be actually less than $35, because we earned that option's premium. We might pick up 85 cents or a dollar per share, so our cost basis would be $35, which is the strike price minus $1, which is $34.
Another type of a trade that we do to initiate these options positions is called a buy-write, where you buy the stock, and then you simultaneously would sell an out-of-the-money call option.
Going back to Intel, let's say you buy it at $36, and you can sell a call option, a $37 call option that expires in a month or so, and you would earn money, the option's premium, and that might be a $1 or something similar to what you would have gotten for the put at $35.
So, you would buy Intel now for $36, you would receive maybe $1 in premium for selling that call option, so your cost basis is reduced to $35, and if you do this in tandem with an upcoming dividend, you can really turbo-boost your income, your returns in fact, from a stock.
Let's say the stock -- let's say Intel -- is going to go ex-dividend in two weeks or so. You can buy it now, you'll be there for the dividend when it's earned, and you'll also have the option's premium.
Now what happens at expiration if you're below the strike price of a call, you just keep on owning the stock? The call expires worthless, you have that advantageous cost basis that I just described, and you can go on and on and on selling more calls until you finally get called away. And you want to really look at the underlying stock.
You can do these kinds of trades with anything, but I prefer to use, you know, dividend-paying stocks, the kind that I wouldn't mind having in my portfolio anyway because in about 40% or more of the cases, you will end up owning the stock after expiration, from what I've found. And the returns have been pretty good.
We've done 535 trades since I started the service back in March of 2014. And on 415 of those, we have no interest in the stock or the option now. The average return for those holdings was 5.7%, and if you annualize that, that's 35.4% annualized. Our average holding period was 90 days. So, it's a great strategy to use for income investors.
You say conservative, and it is kind of conservative relative to other strategies, but keep in mind, you are still assuming the risk of equity market exposure by doing these trades.
You are, you know, your cost basis is lowered, but to think of it as a defensive mechanism would be incorrect. This is kind of like a parachute that would deploy 10 feet above the ground, wouldn't really save you from serious injury if the stock fell to zero.
So, one more thing I want to add, Steven, another kind of trade that doesn't really depend on the, that is not directly tied to the market, are spread trades. You can do spread trades with puts or calls. There are different exotic types, but we stick to bear call spreads and bull put spreads. Essentially, it's like doing those same trades that I just described, but with a little bit of insurance.
So let's say that you're bullish on Apple (AAPL). You could sell a, Apple's around $114 right now. You're bullish on Apple, you think it's not going to go below $112, you could sell $112 put option, but just in case it keeps on going down, you could buy a $110 or a $111 put option, and you'll earn a net credit for that position.
And the worst that could happen is for Apple to go below the lower strike price, and in that case, you could close out the position early and then do the transaction on different options that have different expirations and strike prices.
And the bear call spread is if you're kind of bearish on something, you could sell a call that's priced just at, with the strike price just above the current price of the stock, and then as insurance, you buy a higher price, a higher strike price call. So, if it goes up above it, that's your maximum loss.
Your maximum loss is defined as the difference between the strike prices minus what you received in a net credit. So, you're looking for a position where you can earn something that's about half as much as you will possibly lose. But like I said, you can always close these things out early for a smaller loss, not incurring the maximum loss.
The advantage of using spread trades is that it requires much less capital than buy-writes or selling puts, because when selling puts or doing buy-writes, you have to deal with multiples of 100 shares of stock.
So you can imagine anything that's a stock that's $50, you're talking about $5,000 of cash or margin, whereas a lot of these spread trades that I recommend require about $500 or so.
So, we've got a whole smorgasbord of options selling possibilities, and the goal in all of these is to generate income while pursuing superior total returns.
Steve Halpern: Now fine - can't let you go, I know you cover four new ideas every week, and as you mentioned, you've now covered hundreds of ideas with great performance records. Could you walk us through perhaps a couple of names that you're currently looking at so that our listeners will get a better idea of how to put this strategy into practice?
John Dobosz: Certainly. Well, I was talking about how we sell puts. We would sell the put on a stock that you wouldn't mind owning, at a price a little bit below where it trades currently. So, recently, we did a put sale on Nucor (NUE), the mini-mill seal maker. The stock was trading at around $45 per share.
We sold a $44 put that expires on October 21, so if Nucor, and we earned $1.12 per share, per option I should say, for doing that. Which is, multiplied by 100, and that's $112. So, if Nucor stays above $44 through the expiration on Friday, October 21, we will just keep our $112 and go on with life to find new opportunities to make more money.
But if Nucor closes below $44 on October 21, we'll be obliged to purchase 100 shares of the stock at $44, but we received $1.12 when we put the trade on, so you would subtract that from the $44 strike price, and you would get $42.88 potential cost basis in the stock. So, the beauty of this is that, you know, you could either walk away with the money, or you could be into a stock at a price that you think is a good price.
Now there's another way to, the other way to do this, well, one thing I wanted to point out, Steven, is that the risk profile for selling puts or selling calls is roughly identical. Meaning that your upside is capped, your downside is more or less open, and it looks like a line that goes up to the northeast and then goes flat.
So, there's really equivalent transactions, and if you're looking to establish a new position, maybe you want to sell puts because generally, your potential cost basis in the stock will be lower.
The difference, where it really makes a difference though for doing a buy-write is if there's an upcoming ex-dividend date, and you want to be on board as an owner of that stock so that you can get the dividends, you can also get the call premium that you did, that you got for selling the stock.
Something that we did this on recently, we bought Qualcomm (QCOM) at $62.41, we sold at $62.50, just out of the money, just out of the money call that expires on October 21, but the Qualcomm will be paying a dividend between now and then, so we'll earn that in addition to the premium, and hopefully have another sensational story to tell about our great returns.
Just recently, we did an Apple trade. Apple released the iPhone 7 to great fanfare, it was sold out, the stock was very highly responsive to that. It jumped from about $103 up to about $115, then it backed off a little bit. We did a bear call spread on Apple. So, Apple was trading just below $114. My thesis here is that Apple, before making another new high, will have to fill that gap.
There's an old maxim on Wall Street that gaps must be filled, so that big gap from about $105 to $110 or so might need to be filled. That's my theory. And so, what we did is we sold an Apple $116 strike price call that expires October 21, and we bought an Apple $117. This is, like I said, a bear call spread. So, we earned more money than we spent, so we got a net credit of 34 cents per share, per option, and we did six contracts.
So that would be, it's $204 that we earned today. The worst that can happen is that Apple closes above $117 on October 21, in which case our maximum loss per contract would be $1, would be the difference between the strikes, minus 34 cents, which we received in premium, so that brings it down to 66 cents per share.
So that's the three flavors of what we do, illustrated with recent trades, you know, the bear call spread on Apple, the selling the puts on Nucor, and doing a buy-write covered call sale on Qualcomm.
Steve Halpern: Again, our guest is John Dobosz of the Forbes Premium Income Report. A fascinating topic. Thank you so much for sharing your ideas.
John Dobosz: I hope your people can make it out to Dallas and see me talk about it October 21.
Steve Halpern: Fantastic.
Editor’s Note: John Dobosz will be a featured speaker at the upcoming MoneyShow Dallas, October 19th through 21. Register for free here.
By John Dobosz, Editor of Forbes Premium Income Report
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