Dividends Are Under Siege. Here’s How to Rebuild the Income That Came From Them.

Articles From: Barron's
Website: Barron's

The coronavirus is attacking us and menacing our financial security. The U.S. death toll is expected to surge in the next two weeks, but you can and should fight back in any way possible. That applies to your portfolio, too.

Dividends, which provide many people with tax-advantaged quarterly income, are under siege with companies conserving cash as the global economy withers.

Boeing (ticker: BA), Darden Restaurants (DRI), Delta Air Lines (DAL), Ford Motor (F), Freeport-McMoRan (FCX), Macy’s (M), Marriott International (MAR), and Nordstrom (JWN) have suspended dividends. Apache (APA), Occidental Petroleum (OXY), SL Green Realty (SLG), and Old Dominion Freight Line (ODFL) have reduced their dividends. Others will follow.

Goldman Sachs told clients to expect a wave of dividend suspensions, cuts, and eliminations. David Kostin, its chief equity strategist, recently told clients in a note that payouts could decline by 38% over the next nine months, which would make them 25% below 2019’s level on a full-year basis.

Most people can blunt that impact by rebuilding the income they need to cover living expenses that came from dividends. Investors can create “conditional dividends” by selling downside put options or upside call options on stocks that they own.

What’s the condition? A willingness to buy a stock at lower prices or to sell a stock at higher prices. If those terms are attractive, you can often collect options premiums that are greater than the dividend you are replacing or supplementing. Be aware, though, that conditional dividends are taxed at personal income rates, unlike traditional dividends.

The conditional-dividend strategy is simple. Review your portfolio. Confirm that options are listed for your stocks. Confirm that you are approved for options trading with your brokerage. Next, focus on options with strike prices that are about 5% to 10% above or below the stock price. Pick options that expire in one to three months. Options premiums are often trading at historically high prices since the virus humbled stock prices.

Selling calls against stock you own is called “overwriting.” Selling puts on stocks you own is called “underwriting,” or cash-secured put selling. Don’t get lost in options lingo; focus on the strategy. You are selling options against your stocks on a one-to-one basis to generate income, which also hedges your stock by the amount of the options premium.

Consider Boeing, which until recently paid a $2.05 quarterly dividend. With the stock at $130.45, investors could sell the May $145 call for about $15 or the May $105 put for about $12. Selling a call obligates you to sell stock at the $145 strike price. Selling a put obligates you to buy stock at $105.

At expiration, if the stock is below the call strike price or above the put strike price, investors keep the options premium. Selling one Boeing call, for example, generates $1,500 per 100 shares of stock, compared with the $205 that had been generated each quarter by the dividend.

You don’t need to set aside cash to sell calls against your stock; your stock backs the options. To sell cash-secured puts, you need cash to cover the potential stock purchase price.

The key risks to these strategies are that the stock rises above the call strike price, and you must sell stock or cover the call at a higher price. If the stock falls far below the put strike price, you must buy shares or cover the put.

About 45% of a stock’s historical return is fueled by dividends, and another 3% tends to come from inflation. So, half of successful investing basically comes from picking a stock that pays a dividend and can grow because the business is solid. By enhancing or replacing dividends with the conditional-dividend strategy, we can harness powerful financial forces as we fight an invisible enemy that means to do us grave harm.

Originally Posted on April 2, 2020 – Dividends Are Under Siege. Here’s How to Rebuild the Income That Came From Them.

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Disclosure: Options Trading

Options involve risk and are not suitable for all investors. Multiple leg strategies, including spreads, will incur multiple commission charges. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD) or visit ibkr.com/occ