Journalist Recommends Replacing Dividends with Options

Options

Steven Sears has been writing columns promoting options trading for individual investors since 2006. He’s now suggesting that they use options to replace dividends.

Dividends have always had a special place in the hearts of many investors, a love affair that continues even in the face of the economic crisis that we are in the midst of right now.

Rather than serving to scare them away, especially with many companies being forced to drastically cut or even eliminate their dividends these days, there are a lot of investors who have become more excited about dividend plays, often even more excited, and we’re even seeing people remortgage their houses to put more money to work chasing dividends, a scary enough notion in itself.

The big problem with being content on focusing on dividends is that this approach treats common stocks as if they were price neutral, where the only variable in play is the income that you generate from these dividends, and that’s also scary because it chooses to expose ourselves to the maximum amount of risk and then choose to completely ignore it.

There are even people who aren’t bothered at all when they lose half or two thirds of their investment in a stock as long as they are collecting this chump change along the way. Gaining a relatively small amount in dividend payments but bearing much more in capital losses has us seeing investors coming out of these scenarios with a dumb smile on their face often times, which is also pretty scary.

No one is the wiser if you are both content to ignore the risk of capital losses and even those losses manifesting, and are also ignorant toward the relative loss of capital gains versus what you could have made investing in other stocks of significantly more potential to make money off of overall, because if you don’t think that any of this matters, it won’t matter to you.

This is obviously not the time to be ignoring how the value of our portfolios may be changing, especially in the face of data such as another 6.6 million more unemployment claims this week, bringing the total to 10 million now. Of course, people are out of work, because they are being penned in at home by way of government decree. This is not good for business or stocks though of course.

If you don’t care how low your stock will go, you won’t care, but this is not an effect that we can just pretend does not exist or that there is a strategy, presumably theirs, that renders big downward price swings in your portfolio meaningless. For those who do dare to peek and may be unable to beat back the part of their brain that is seeking to guide them on a more sensible path, the weapon of choice is the misguided notion that you only lose on price when you sell, which you don’t have to worry about if you choose to just hang on instead.

What we end up doing is chasing losses when this happens in the face of a big downturn, such as what we just saw. You might become excited that your dividend rate has doubled when a stock just lost half its value over a period of a few weeks, if they are able to maintain it that is, but over this time, you could have avoided losing half of your money on this by simply not being in the stock during this dire time, something that runs completely counter to their refusal to not only protect themselves during these times, but to wear their ignorance and utter recklessness as a badge of honor.

Some of these investors have had reality impinge upon their dividend fantasies enough to perhaps be more open to taking a different approach. Columnist Steven Sears is a champion of options for the everyday investor and he’s happily stepped up to suggest a way that investors may be able to replicate dividends selling options.

If you know much about options, the very idea of everyday investors selling options should send a shiver through your spine. Chasing dividends is one thing, but selling options takes your strategy from the frying pan directly into the fire, and this fire can burn even hotter than just dumping half your portfolio due to sheer negligence.

We run into the idea of selling covered calls here and there, which under the right conditions isn’t that terrible of a strategy, when things are really flat, although the small returns we get still doesn’t justify the risk. If investors did get a hankering for selling options that they cannot force themselves to turn away from, in times of relative calm, this is at least not something that we will lose the house over.

Selling covered calls is at least covered by your stock positions, and the way that this works is that if your stocks don’t go up, you pocket a little change from those who bet on the price going up and lost. If you are on the wrong side of this and the price does go up, you have to sell stock to cover your risk and you basically take the profit you would have made over this time and give it to the options traders you promised to.

Given that the goal with long positions in stocks is supposed to be to capture returns based upon the price of our positions rising, we may wonder why people would pursue a strategy that trades this for replacing this profit potential with one considerably smaller, even if we are only covering a portion of our portfolio with this.

This can seem to work in flat markets, and this is the only time we should ever think about this, but in flat markets, you still have an unfriendly risk to return ratio compared to other approaches investors can take. We are never always right about these things and there is a risk of stock prices going up even during bear markets, and perhaps especially so during downturns as we are prone to rebounds that can suck up the amounts we need to recover from the losses we took on the way down while holding these positions.

Money is made selling calls, but this really needs to be left to the professionals who know far more about what they are doing than ordinary investors do, especially given that options trading is purely a game of skill. The amateur money continually flows into the hands of the skilled traders, and if you don’t trade options for a living and have a strong track record doing so, you aren’t among the skilled.

Selling puts is a whole different story and a whole lot scarier for individual investors, especially in a bear market, and this is where the shuddering really needs to come in as the risk here is severe during these times. Selling covered puts is called overwriting, and selling puts while holding long positions in an asset is called underwriting, and underwriting is a whole lot more dangerous.

You can cover the puts you write by pointing the direction of your underlying assets in the same direction. It’s not as if this is a wise thing for investors to do, for the same reasons that it’s not really wise to sell covered calls, but covering puts involves both selling your long positions and turning them into shorts in order to align your underlying position with the direction of the options trade, something that is even more out of the element for the great majority of investors.

Uncovered options selling, like selling calls when you don’t own the stock or selling puts when you haven’t shorted the stock is called naked options selling, also referred to as naked options writing. Writing and selling mean the same thing, but we’ll confine ourselves to calling this selling because the term is more intuitive.

If being short the stock is safer than not owning it at all and having to cover all losses out of your cash balance, being long a stock that you sell puts with is even more dangerous, because you not only have to cover your losses with cash, you also lose on your stock positions as well when things run against you.

Naked put selling doesn’t quite describe this situation, and we should distinguish between the nakedness of backing options with cash and having a reverse position in the asset, which we could call stark naked put selling perhaps.

If you sell puts stark naked, when your stocks are at $100, and they go down to $80, you essentially double your losses with this, losing 20% on the stock and $20 with the option. You have doubled your risk and your losses here, leaving yourself twice as naked as someone who just sells naked puts, where even your bones are exposed to the world, from all the excessive weight loss that this strategy can cause.

The ultimate nakedness though is a strategy that has you doing both at the same time, selling both covered calls and stark-naked puts, a strategy that belongs more in a twisted version of Alice in Wonderland and certainly not in an everyday investor’s portfolio.

Giving Up Your Upside and Doubling Your Downside Losses Is Just Madness

Steven in Options Wonderland has not shown that he is restrained all that much by sensibility, and we’ve looked at a couple of his options strategies for everyday investors in previous articles, and he’s the go to guy if we’re looking for half-baked options ideas in the mainstream financial media.

This dish is far from half-baked though, and even deserves to be nominated as the craziest options trading idea ever. As bad as this idea is, it stands out even more when dished out in the face of the massive market volatility that we are facing, which multiplies the already crazy risk of this strategy many times.

His idea is to try to simulate dividend payments with our long stock positions, given that dividends are in such peril these days. At least he recognizes the risk with dividends, and pursuing dividends is a stupid enough idea, but he has found one even more stupid, which is no easy feat.

We pray that not too many investors who read his columns will fall prey to this, but what really concerns us is that this is aimed at a sector of the investing world that is particularly clueless, and the fact that they are dividend chasers in itself finds them guilty.

Sears calls this a “conditional dividend” strategy, something he has been promoting for years and has dusted it off again and threw it in the face of his readers. What stands out so much this time is that this is a time where such a strategy is particularly dangerous, but that has not dampened his enthusiasm and has even seemed to increase it.

The reason why Sears calls these dividends “conditional” is that it is based upon the condition of a “willingness to buy a stock at lower prices or to sell a stock at higher prices.” The condition of selling stock at higher prices is simple enough to understand, but the one that involves buying it at higher prices is a slick way to gloss over what is the massive risk of stark naked put selling.

Dividend investors who aren’t really that interested or perhaps not interested at all in the capital gains that most investors shoot for when they invest in stocks might not see their giving up this upside with their stocks a big deal, but this is where the real money is made from stocks these days. Sears tells us that 45% of returns from stocks have been from dividends, but this invokes ancient history in a way that does not make sense given that that recent history has a much bigger proportion of returns coming from capital appreciation.

The condition that Sears neglects to mention is that the premiums need to be very high for this to even approach the income that dividends generally provide, and we really don’t see periods of volatility this high very often. During normal times, the premiums that you make when these trades go right are too paltry to even worry about, and this does not even account for all the risk involved in covering your losses when the trades go against you, which you have to deal with in full measure when they happen.

Sears uses premiums from this week, with the VIX still running red hot and way above historical norms. The VIX is used to try to gauge volatility with the stock market mostly, and this is correlated pretty well, but it directly measures volatility with options, which is how the number is calculated. The higher the VIX, the more volatility options contracts have, and when you are selling options, this also measures the amount of risk that options trading involves at any given time.

The premiums on both the call side and the put side are much higher than normal right now, high enough to make the premiums that we earn when the options we sell expire worthless to the buyer and allow us to keep the whole premium seem competitive with dividends.

We aren’t really told what happens when we do this full-time, as is advocated here as a means to replace the cherished dividends that are at so much risk. With these “conditional dividends” only replacing a much smaller percentage of the dividends that people seek during normal times if the plan works, and exposing investors to a lot of needless and even crazy risk when things don’t work out, this is indeed a strong candidate for the craziest investing idea of all time.

It is the way that the risk plays out that makes this idea so crazy. On the upside, the reason why he tells us that one of the conditions of this plan is to sell stocks when the price goes up is that we will need to do this to cover our options losses, selling a portion of our stocks and not pocketing the gain, but basically giving the proceeds to the options buyers that we owe this amount of money to.

It is the selling puts side that really exposes the foolishness and recklessness of this plan though. Putting a condition as being willing to sell stocks if they go up does serve to cloak the true nature of what is going on, which would be more accurately described as being willing to give up stock, but this is nothing compared to how much telling us that we need to buy stock when it goes down seeks to cover up what really happens.

In this case, the correct description would be to cough up whatever amounts you lose out of your own pocket. Just like you don’t get to keep the proceeds when you sell your stock when it goes up, you don’t get to keep the stock you need to buy when the price goes down, you buy it and just hand it over, which is the exact same thing as suffering a cash loss.

This Idea Would be Fabulous if the Goal Was to Lose as Much as we Can

We aren’t even told to manage these risks, as presumably you would hang on to your options positions until expiry and experience the maximum risk and losses, but suggesting that you actually manage risk in any way takes this from a simple plan, albeit a simple-minded one, and makes things more complicated, where you actually have to employ some skills to get along.

We’re also not told what to do when our bad options trades expire, leaving investors to guess at this, but since you are supposed to be in on both sides at all times so the guess to keep chasing would have to be an accurate one.

People who actually know what they are doing will close their positions when the risk gets too crazy, where you lose the difference between the premium that you collected and the one that you had to pay to bail, which can be painful but does not come with unlimited pain.

Sears’ strategy, on the other hand, has us put down this shield and remain in the sword battle to the bitter end, no matter how bad it may be going. All the while, you are holding fast to your long positions in your stocks and are suffering losses from them as well, as you’re not supposed to sell these stocks beyond covering puts that you sold that have punished you.

In reality, people aren’t going to want to keep large reserves of cash to cover options losses, and it would be stupid enough to do this anyway, and to significantly dilute our stock positions to do this is going to take the dream of simulated dividend returns from premiums even further into the depths of outer space.

What people would be forced to do instead is to liquidate their stock positions on the way down to cover their losses, which actually makes more sense than holding a lot of your money in cash for this because we at least are selling with the trend.

Even though one approach may make more sense than another, this does not mean that either meets the threshold of sensibility, and both fall well short of this, by a scary amount actually.

The scariest part of this strategy is what happens as this plan unfurls, which involve exclusions to both the up and down side along the way. Each time we get a notable move up, we dilute our equity by having to give some away each time. We end up choking ourselves on the upside, where for instance if a stock goes up 50% we give that away, which in itself makes moves to the upside a lot riskier.

If you buy a stock at $20, and it goes up to $25 and then down to $20, then back to $25 and then down to $20, the stock hasn’t moved at all and just holding it would have you even. The conditional dividend plan would have us not only giving up some of these two 25% moves up, it would have us lose extra money on the way down.

If all of these moves happened within the life of the options contracts we sold, and we started with 1000 shares of this stock, just one of these moves is going to hammer us and several together will crush us. To be fair, you would only see moves like this happen during the life of one of these contracts during the most volatile times, like the one we’re in for instance, but since we are here now, we need to take a peek at how much of a horror show this can be.

We are setting our strike price at 10% over the market when we sell these, and these are 25% moves, so we lose 15% of our stocks each time this happens. Going from $20 to $25 the first time leaves us with 850 shares at $25. It then goes down to $20, and this ride was a particularly painful one, as by the time we sell the shares we need to in order to cover the options loss, we are down to 722 at $20.

The fun isn’t over though, if you find losing money fun that is, because there is another round of pain to go. On the next move up, we drop to 613 shares at $25, and then drop to 521 shares when we get back to $20.

The stock hasn’t even moved, but we’ve managed to lose almost half of our money, and this plan actually just doesn’t stop there, it keeps marching on to be further decimated when future moves of this sort happen.

All we have on the other side of the ledger, to not only balance off these losses but provide us with a profit that is competitive with dividends, is the premiums we collect. Not only are these premiums generally lower than what higher dividend stocks pay historically, our contrived plan has added a lot of downside to this and enough to at least have this considered as the most brain-dead investment strategy we could ever attempt.

We’d even have trouble thinking up a worse one that involved continuing to hold your money primarily in stocks and keep them, even though there are things that could do with options trading itself that are much dumber, such as putting all your retirement money in a call option with a strike price that is very unlikely to be hit.

People don’t do things quite this stupid, although a lot of amateur options traders see options much like playing the lottery where they do shoot for prices well outside a sensible range. This has them standing alongside hedgers who know they will lose overall but are doing it to protect themselves, while these neophyte option traders are trying to speculate this way at a decided disadvantage.

You have to be better than the average trader when you trade in options, either on the buying side or the selling side, and this takes down the great majority of new options traders who have a lot more knowledge and experience than investors and still get handed their lunch.

This is not the worst of it, as if investors took a portion of their wealth and actually tried to trade options for profit and not for some other contrived purpose, their strategies would at least be a little aligned with the task of trying to profit from this. They still would be handed their lunch, but in a way that would serve to be a much better lesson of the bankruptcy of the idea that they should be trading options than pretending that this is like dividend investing.

As bad as ignoring losses when investing for dividends, this idea takes the ignorance involved here to a whole new level, where you now get punished when your stocks move a lot in either direction.

We could always turn to just looking to hold stocks for overall return, regardless of the portion of it is in dividends and what amount is gained by the price going up. That’s where the threshold of sensible lies. Sears has instead dug a big hole beneath it, and hopefully too many people don’t choose to jump into this pit with him.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: [email protected]

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