One of the perks of using options is yield enhancement. Through the use of short puts and covered calls, derivative traders can take an otherwise lackluster dividend and make it POP! Like adding color to a black and white photo.
Today I want to illustrate exactly how its done using shares of Coca-Cola. The soda king just suffered its largest post-earnings plunge in years after reporting lackluster numbers. I think opportunity could lurk amid the rubble. If nothing else, KO presents an interesting case study for using options to boost your returns.
As of Friday’s close, KO stock sits at $45.24 and boasts a dividend yield of 3.45%. Any further damage to the share price will boost the yield even higher.
While 3.45% is actually a fantastic rate of return these days, let’s see how we might use options to amp things up a bit.
First, rather than buying shares outright, we could start by selling puts. Think of it as a way to get paid for our willingness to purchase KO. Right now we could sell the March $44 put for 35 cents.
How does this enhance our yield? Well, even if we only sold one put for every 100 shares we’re willing to buy, the 35 cents still translates into an annual return of 11.61%. In other words, if you continued to make $35 on $4,400 every 25 days, you would rake in 11.61% over one year.
By using short puts as your vehicle you are not entitled to the 3.45% dividend. But, who cares? Assuming implied volatility levels remain similar throughout the year to what they are now, the short put route should net around 3x that amount.
The only outcome where you’ll end up better off if you had bought KO shares outright is if the stock rockets higher over the next year. I consider that a low probability, particularly because this quarter’s earnings misstep will likely hang over the company for a spell.
And speaking of probabilities, the March $44 put has a 27 delta which nets you a probability of profit of 73%. Investors who buy KO outright only have a 50% chance of gain over the same time frame.
One management idea if Coke continues to tumble is to allow assignment. If the stock sits below $44 at expiration then you’ll buy 100 shares at a cost basis of $43.65. That’s a 3.5% discount to Friday’s closing price.
What of Covered Calls?
The alternate route to yield enhancement is buying KO stock now, but selling calls against it. For example, you might sell the March $46 call for 42 cents. The premium received translates into an approximate 1% return for the next month. Annualized, that’s north of 12% on top of the 3.45% dividend.
Now, obviously, this is an oversimplification. Some months the stock will rise, and you’ll have to buy back the calls at a loss to avoid assignment if you want to keep your shares. But, even if a volatile ride causes your call selling to only add 4% extra yield over the year, it still more than doubled the rate of return.
Some traders elect to use both strategies. Sell puts until assigned, then buy shares and sell covered calls until assigned. Rinse and repeat.
The key takeaway is that once you realize you can get paid to buy and sell stock, it opens up a whole new world. When I come across situations like KO – where a large-cap dividend payer gets whacked on bad juju that I think is temporary – I like the idea of using short puts or covered calls to increase my odds.
That’s catching a falling knife – options style!
Financial freedom is a journey
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