SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

What Options Traders Need to Know About Dividends


Higher dividends are better, right? Yes, usually. But not always. Dividends are a fundamental indicator and many options traders are not interested in fundamentals. But as a means for picking stocks on which to trade options, some fundamentals offer great insight.

If you use any strategies that combine equity positions with option hedges or cash generators, you need to know how to pick the right stocks. So covered calls, protective puts, covered straddles, and many more strategies should be opened on the best possible companies and their stocks.
 

Picking stock just for maximum yield (on both options and dividends) is unwise because it is likely to expose you to greater volatility and market risk. Options trading is not isolated from stock performance, and that grows from well-picked companies – meaning fundamentally strong, consistent, and competitive companies. Weak companies often reveal higher than average dividend yield and option premium, but not always for good reasons. These can be danger signals that every trader should know.
 

Dividend achievers and dividend aristocrats

Companies increasing dividend per share for `10 years or more are called dividend achievers; those increasing dividends consistently for 25 years or more are called dividend aristocrats.

These are important and distinguishing features for one reason: These companies with exceptional dividend record also tend to out-perform the market in the long term. Not all, but most, have demonstrated lower market risk and consistent returns in the stock prices, dividends, and options.
 

As a starting point, checking the status of dividends per share is a strong indicator. But it is not the exclusive test of whether a strong dividend record is enough.

 

Growing dividends and growing long-term debt

Dividend should always be understood in the context of how a company funds those dividends. You might have noticed that some companies report net losses in certain years but continue to raise dividends. Is this accomplished from cash reserves or from somewhere else?
 

Observing ever-higher dividends per share over many years is only half of the total equation. Also check the status of the debt-to-capitalization ratio. Total capitalization is the combination of long-term debt and stockholders’ equity. Dividing long-term debt by total capitalization reveals the percentage of total capitalization represented by debt.


If this ratio is increasing over several years, it is a red flag. The more a company relies on debt and the less on equity, the more future earnings will have to be used for debt service, and the less will be available for expansion and dividends.


Some companies take on increasing long-term debt to finance dividends when earnings are not high enough to do the job. As the ratio approaches 100%, equity shrinks to near zero. To see examples of where this leads, consider the recent history of one-time solid Blue Chips General Motors, Eastman Kodak and Sears. All of these saw their long-term debt outpace equity and cause bankruptcy.


When dividends increase but a corresponding increase in long-term debt occurs at the same time, those higher dividends are not positive signs. The dividend trend along with the long-term debt trend tells the real story.

 

The problem of higher dividends

Is a higher dividend always good news? No.

You need to evaluate the recent history of the stock price as well as dividends per share. If the share price falls many points, the dividend yield moves up and becomes a larger yield. For example, a $50 stock paying a $2 dividend yields 4%. If the stock falls to $40 per share, that $2 translates to a 5% yield.

A move from 4% to 5% looks pretty good at first glance. But why did the stock price fall 10 points?


If the most recent earnings report included a negative revenue or earnings surprise, that could be the cause for the loss of share price. If the company’s guidance is revised to forecast weaker future revenue and earnings, that also brings down the share price. In this situation, the dividend yield is not as positive as it appears at first glance.

 

The yield you earn is fixed

Some investors with equity positions in a company’s stock tend to track dividend yield often, even daily. This makes no sense.

The yield you earn is going to be based on what you paid for shares of stock. No matter whether the stock price rises or falls, the true yield is the dividend per share, divided by your basis and not by the current price.

The dividend trend is useful for determining whether to keep the position in your portfolio or to purchase additional shares for increased option hedging or cash generation. But your yield remains unchanged.

 

Dividend yield as a starting point in picking stocks

Options traders who also hold equity positions must decide which stocks to acquire for options trading. A popular method is to compare option yield based on premium value and time to expiration. This is not the best method for deciding which stocks to use for options trading; the higher premium often translates to higher volatility. Translation: Higher-yielding options premium equals higher market risk.
 

For some traders, that higher risk is acceptable. But for most, a consistent and reliable level of yield from options trading makes more sense. To pick the best stocks, use dividend yield to narrow down the list of candidates. You will find that if you select only those stocks yielding 4% or more, you end up with a very short list. When a test of the long-term debt trend is added, the list shrinks again. Adding in annual P/E range, revenue and earnings, the final list will come down to a very small number of companies, perhaps under 10.


The methods for picking options range from high-risk to extremely conservative. When it comes to dividends, widespread misconceptions cloud the decision. Many analysts continue to rely on the current yield as the primary test of how a company controls working capital. But combining dividend yield and long-term debt trends tells the real story.


Dividend trends tell a much larger story for options selection than most fundamental indicators. Picking the best option is a function of picking the best stock; and the combination of dividends and long-term debt reveals the long-term strength or weakness of the company’s policies.
           

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

Related articles:

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Important Tips For First Time Currency Traders

    Diversifying your portfolio is important for all investors, and currency investments are a great way to do that. However, there are a lot of misconceptions and common mistakes that first time currency investors make, and this leads to big losses.

    By Kim,

    • 0 comments
    • 55 views
  • Iron Condors or Short Strangles?

    In my early option trading days, I favored selling iron condors over selling strangles. I thought that selling a strangle was too risky because the potential loss was “undefined”. I thought this made sense because this is what I’d hear from other people that were more experienced than I was.

    By Jesse,

    • 0 comments
    • 1,172 views
  • How To Be A Successful Day Trader From Home

    The good news is that if trading is your passion, then it’s possible to become a successful day trader and work from home. However, it’s not as easy as setting up shop and jumping online. There are specific steps and processes you need to have in place if you’re going to be able to make a living for yourself and have a bright career and future.

    By Kim,

    • 0 comments
    • 144 views
  • 3 Key Pieces Of Advice For New Traders

    These days, everyone claims to be an ‘expert’ on absolutely everything. Apparently, it only takes having a Twitter account to be a seasoned expert on any given subject; all in all, the Internet is full of nonsense. It’s becoming harder and harder to find legitimate answers amongst the quagmire of false information online.

    By Kim,

    • 0 comments
    • 208 views
  • Why New Traders Fail

    Our first advice to new traders is: "Learn First, Trade Later". The markets will always be there, but if you start trading without proper fundamentals, your capital will be gone very fast. The barrier to enter trading is so low today, commissions are near zero, and the whole trading game looks very promising.

    By Kim,

    • 0 comments
    • 401 views
  • Lumpy Dividends and Options

    Dividend payments, like oatmeal, may be smooth or lumpy. Smooth dividends are predictable, usually once per quarter. It is easy for options traders to believe these dividends are guaranteed, because they usually continue uninterrupted quarter after quarter. This also makes it easy to predict total return over a longer time span.

    By Michael C. Thomsett,

    • 0 comments
    • 378 views
  • Coming to Peace With Market Volatility: Part II

    On April 18th I wrote part I of this article, Coming to Peace With Market Volatility. I showed how the US equity market risk premium, defined as the annual average return of the Total Market minus the return of one-month US Treasury Bills, was a large 8.37% per year from 1950-2019. That’s the good news.

    By Jesse,

    • 0 comments
    • 415 views
  • Ratio Calendar Spreads

    The ratio calendar spread is well-known to some, but for others the risk/reward aspects are not well understood. One way to cover a short position is to own 100 shares of the underlying stock. Another, more creative way is to sell a shorter-term expiration position and buy a longer-term position.

    By Michael C. Thomsett,

    • 0 comments
    • 824 views
  • Studies Vs. Real Trading

    "Who you gonna believe, me or your lying eyes?" Our members and readers know that buying pre earnings straddles has been one of our favorite strategies that produced consistent gains in the last 8 years with very low risk. Yet there is a significant number of studies showing that this strategy has a negative expectation. 

    By Kim,

    • 0 comments
    • 770 views
  • Should You Hedge or Diversify?

    Using the most popular S&P 500 ETF (SPY) to represent the US stock market, this article will look at different ways to manage equity market risk using historical ETF and options data from ORATS Wheel since 2007. We will analyze the following unhedged, hedged and allocation choices:

    By Jesse,

    • 11 comments
    • 1,140 views

  Report Article

We want to hear from you!


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoji are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs Expertido