In last week's blog, which you can read here if you like, we laid out the three steps to utilizing the Ultimate Dividend strategy in your options trading. Today, we are taking a more in-depth look at step 1, which is finding a dividend-paying stock that you want to own.
The first step is to find the "property" you want to use this strategy on. It is not strictly necessary to buy a stock that pays dividends as you can sell put and call options on any optionable stock, but this is a cash flow strategy, so it makes sense to maximize your potential cash flow by buying a stock that will pay you just for holding it.
For this strategy, there are four requirements that the stock must meet:
Why is that last rule important, you ask? Because each option contract controls 100 shares of stock, you must buy the stock in 100-share increments. If you sell a put option on a stock and the stock is assigned to you, but you can only afford to buy 87 shares, you will lose money.
Similarly, if you sell a call option when you only own 87 shares of the stock, then when your call option is exercised, you will owe more shares than you own, and you will lose more money by having to buy more shares at a higher price just to give them away. To avoid any issues, you should always plan on buying the stock in 100-share increments.
When it comes to buying dividend stocks, there are some points to consider when deciding which stock is best to buy. Two of the most important factors are the dividend yield and the dividend coverage ratio.
The dividend yield is how much the company pays to its shareholders in dividends. This is calculated as how much dividend you receive per share, divided by the shares' price. For example, a $10 stock that pays a dividend of $1 has a dividend yield of 10%.
It's important to note that dividend yield is an annualized number. Most companies pay dividends quarterly, while some pay monthly and others pay semi-annually or even annually. In the previous example, if the $1 dividend was paid quarterly, each quarter you would receive $0.25 for every share that you owned.
All else being equal, you should try to receive as high a dividend yield as possible. However, all else is never equal. Generally, companies that pay high dividends tend to be in distress and have to pay a high dividend to attract capital because they come with higher risk. Very safe, large companies pay small dividends because they have relatively little risk.
Another critical metric to consider is the dividend coverage ratio. This ratio tells you how many times over a company can afford to pay its dividend. You can find it by dividing the company's net income by the dividend amount. Suppose the company from the previous example has a net income of $100 million and will pay its $1 dividend to 40 million shareholders. In that case, it has a dividend coverage ratio of 2.5 (100 million divided by 40 million equals 2.5). This means the company makes more than twice as much money as it needs to pay its dividends.
There are two schools of thought when it comes to dividend coverage:
As usual, I find that it tends to pay to go against conventional wisdom, but of course, this has its limits. A company that pays 110% of its net income to shareholders cannot sustain that payout level. Eventually, the dividend will be cut.
Additionally, the company must have a relatively steady net income and dividend payment history. A company whose net income fluctuates wildly from year to year will find it hard to pay a consistent dividend. Remember, you will own this stock for at least a month, if not a quarter or more so do your best to choose a company with a strong history of paying a large amount of income to its shareholders.
That covers step 1 in detail and remember to check back next Thursday for complete coverage of step 2. Thank you for reading!