Fiscal Cliff – Using Option trades for Dividend Plays

As we all know, several companies are rushing to issue dividends this month to avoid (much) higher dividend taxes if there is no resolution to the fiscal cliff negotiations post Jan 1, 2013. This post is about using Option trades for dividend plays and there are many big companies in this pack. Walmart, Costco, Las Vegas Sands are all issuing fairly large dividends. The Chicago Tribune has a complete list here –

So how can we play the dividends game ? In general when a stock issues a dividend, the stock price falls by an amount approximately equal to the dividend. Also generally, the stock recovers this amount fairly easily. Take the example of Costco (COST) – its planning to issue a dividend of $7/share. Its currently trading at around $105 (rounded up). So whenever the ex-dividend date comes along, COST shares will come down by approximately $7. Now in general, strong stocks (and COST is definitely a strong stock) will recover this amount of $7 in some time – say 3 to 5 months. It may happen sooner due to other fundamental reasons, but even in the absence of any fundamental reasons, its reasonable to assume it will happen. The obvious caveat here is that the broad markets could nosedive if the fiscal cliff negotiations fail, or due to a myriad number of reasons which we know as “Market Risk”. But we ignore these for the sake of understanding the specific trade strategy.

Post the dividend date (and perhaps any big gyrations produced by the markets based on the fiscal cliff deal), you could buy shares of COST in multiples of 100 – say 100, 500 or 1000 depending upon your capital available. You’ll get it at a good price (ex-dividend and maybe some fiscal cliff effects). Once the markets stabilize (and they should stabilize in some time even if there is no deal) after the new year and COST tries to make its way up again, you can sell Monthly Calls at about $5 Out of the Money each month. This is your standard Covered Call strategy, but what makes this a safer strategy is the fact that COST is not going make up the $7 dividend in a hurry. This is a large dividend, and no company, even one as good as COST will make up this ground in a month or two. So if you bought shares at say $95, then selling $5 strikes OTM Calls for a period of 4 to 5 months could get you at least $10 in premiums. This would then reduce your cost basis of the COST shares to $85/share. This is a very attractive price point to own COST even for the long term.

The other potentially great trade is possible if there is no deal and the markets crash for a couple of weeks. COST (Beta of 1.2) will also crash a bit more than the S&P 500 because of its Beta of 1.2. This could mean COST could be trading at 80 to 85 per share ex-dividend and fiscal cliff effects. Write some Put Options at $80 or $75 strike prices if you don’t mind owning it at these prices. If you pick up the stock, that’s great – if the stock does not hit your Put strike, the premium is yours.