Get naked for yield

August 25, 2015 01:00 PM

Everyone is looking for yield. Where can we find a decent yield that is relatively secure? Bonds are not the safe haven that everyone assumes they are. Why would you accept these ludicrously and historically low rates and think that they are safe?

The U.S. two-year note yields a paltry .058%, while the German two-year note (Schatz) yield is negative! 

Of course, today you can buy a Greek two-year bond with a 50% coupon, but the chance you will ever see the principal is doubtful (at least not in euros). 

This leads us to what may be the safest yields around. Namely, solid stocks that pay a decent dividend with a good history of increasing their dividend over a multi-year time frame.

While there is no free lunch, dividends may be as close as it comes. It makes sense for companies to pay a portion of their profits to their owners; which is not, contrary to the views of some, the over-compensated management, but their actual owners, i.e., the shareholders.

What should you look for in a dividend stock? A solid history of paying and never missing a dividend, with steady dividend growth. A solid blue-chip stock that will still be around for our grandchildren.

Real Estate Investment Trusts (REIT) have tempting yield profiles, but they also have earnings and dividend volatility that make them less than ideal. If you are a conservative investor, you want stability and security.

Which brings us to good old AT&T (T). At its current (July 7, 2015) price of $35.80 it has a respectable dividend yield of 5.25%. Furthermore, it has a 30-year history of increasing its dividend, making this stock an excellent choice (see “AT&T cash dividend history”).

But there are better ways to access this dividend yield than simply buying the stock and perhaps selling an out-of-the-money call against it. A better strategy is the Cash Secured Put. That is selling an out-of-the-money put “naked,” secured only by the money set aside to take delivery of the stock if assigned. Only sell naked puts if you are absolutely willing to take delivery of the stock at the strike price where you sold the put. Our reason for doing this in AT&T is because of the dividend yield and the stability of the stock.

Let’s look at the September 32 put. We choose the 32 strike because the 52-week low in AT&T is $32.07, suggesting that there is support at that level.We select September because you want the option to have enough time premium to be worth selling.

Let’s say we sell the September 32 put 10 times at its current price of 25¢, or $25 collected for each put sold. We set aside $32,000 as cash security if assigned (each put represents 100 shares). This cash, however, may be in the form of an interest-bearing asset such as a Treasury bill.

What can happen? If AT&T is above $32 at the September expiration we collect $250 and can move on to a different expiration cycle. If it is below $32 on expiration we are assigned on the short put and take delivery of 1000 shares of AT&T at an effective price of $31.75 (32 minus the 25¢ in put premium).

At 31.75, T has a dividend yield of not its current 5.25%, but a whopping 5.92%. Then, if desired, you can sell an out-of-the-money call and turn the position into an old fashioned covered write.

This is a win/win strategy that offers very good yield: Either in the form of the short puts expiring worthless or getting an above current market dividend.

About the Author

Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Liss has educated and mentored traders since 2006.