Updated: Oct 4, 2019
I've already shared some videos on dividend growth investing and basic option selling strategies as it is far more effective than just holding onto your shares and not getting paid for the volatility risk you take on. In that regard, let me present an attractive long-term buy and hold opportunity to you in order to illustrate how you can lower your portfolio deviation while doubling your dividends and benefiting from swings in volatility. This was also one of my topics addressed in my seminar in Belgium when I was talking about defensive option strategies to improve our chances of success. Let me be very clear that option selling when used properly (and thus with sound portfolio sizing) is not about gambling, it's about reducing our directional risk which buy and hold investors face.
Let me highlight the following example for you:
* Public Storage is a storage REIT with an excellent trackrecord, balance sheet and skilled management team. The company enjoys robust NOI growth and pays a healthy dividend yield of 3.3% right now. When you own shares, you get whipsawed because of irrational price action and swings in volatility. Isn't there a much smarter way to create more income while locking in gains in share value and collecting the dividends? Let's have a look.
Including the dividends, the trailing annualized returns are 12.9% on a 15-year time frame; 15.8% on a 10-year time period and last but not least 11.1% on a 5-year basis. Pretty consistent and market-crushing returns so why would we even consider implementing another strategy as buy and hold has proven itself 'unbeatable'. That's at least what most retail investors - including me until one year ago - believe. But what if shares flatline at current levels? That's exactly what has happened over the past 4 years. Except from receiving dividends, you didn't make a lot of money holding onto the stock. Going into risky and exciting assets and exiting these boring investments carries a lot of risk. Just sell out-of-the-money calls!
I have to admit that low-volatility (low-beta) stocks are not as sexy as one would think, but they provide investors with decent and - even more important - consistent returns. The funny thing about Public Storage is that the implied volatility is often higher than the S&P's while it still offers a far better Sharpe Ratio and had less market correlation.
Now, this stock proved to be an excellent investment, but will it continue? Let's throw the odds into our favor by selling out-of-the-money calls to capture dividends, premium and upside potential. Reap benefits when volatility is pretty high and your investment success will be even bigger (remember the fourth quarter of 2018, great times for option sellers; apprehensive period for buy and hold investors who started to doubt their investment strategy). The lower the implied volatility, the lower your premium will be and that's why long-term covered call writers should stick with two-month or three-month options to capture sufficient premium.
Covered call writing on conservative buy and hold positions is a great way to perk up your future returns and it doesn't involve a lot of work. Let's dive into the options chain for Public Storage to see what strike prices can be considered attractive for long-term investors.
Shares are now trading at 243.45 dollars. Selling the November 15, 2019 calls with a strike price of $260 means there's a 21.9% chance that shares will be trading at or above $260 within 60 days. That probability diminishes once you go further out in price and select the $270 strike which has a 9.6% chance of ending up in the money. Stated differently, the more you go out-of-the-money, the lower the premium, the higher your maximum profit can be and the longer you can benefit from share appreciation. It depends on where you possibly want to part with your position. Keep in mind that although the options market is not that tight in PSA, we can negotiate a better price by setting our limit order at mid-price. Delving deeper into the mathematics behind selling covered calls, you'll spot the following elements:
Including the dividend (which automatically results in a much lower call premium and a higher put premium) and without factoring in any upside potential, you just got paid an annualized 11.4% selling an out-of-the-money covered call with a 22% chance of being in-the-money at expiration.
If shares go to $260, you'd lock in a gigantic return in excess of 52%! The beauty of selling out-of-the-money options is that you can retain your shares while accumulating gains at least to some extent since we're capped on the upside. Above $260, things start to take another look with our maximum profit potential standing at an annualized 52%. We can't generate more profits in share value beyond the strike price.
Looking at the $270 call, the potential annualized return is much higher, but that's mainly due to the greater upside potential (an additional $10 per share compared to the $260 if shares go up to $270).
On an annualized basis, you can easily double your dividend yield while enjoying the profits from a potential rally up to the strike price.
If shares expire below the strike price, you keep the shares, you retain the dividend and the premium. We no longer have an obligation, so we're free to sell a new covered call for the following two months until you want to exit your position or when you feel that there are better opportunities for your capital. Wash, rinse, repeat!