Be a Seller of Volatility

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Most people stay away from options, and for good reason. But selling options can be a lucrative and conservative strategy, especially when the volatility of the stock market is high. Goldman Sachs recently published a list of 25 stocks with unusually high volatility which could make good candidates for selling put options. By selling a put option you obligate yourself to buy shares of the underlying stock at the strike price if the option is exercised. If you sell an out-of-the-money put option, with a strike price below the current market price, the stock would have to fall in order for the option to be exercised.

The number one rule of put selling is this:

Only sell puts on stocks that you want to own at a strike price which you're willing to pay.

Selling puts on stock you don't want to own will almost certainly lead to disaster. Don't chase premiums.

The interesting thing about Goldman's list is that it contains a lot of high-quality dividend stocks, some of which are part of my Ultimate Dividend Growth Portfolio. These stocks typically carry low option premiums, but in the current market those premiums are elevated. Let's look at three stocks from the list, two of which are part of the portfolio: Lorillard (NYSE: LO), Clorox (NYSE: CLX), and Exxon Mobil (NYSE: XOM).

The highest yielding cigarette stock

Lorillard is known for the Newport brand of menthol cigarettes, one of the most popular in the United States. Lorillard is part of The Ultimate Dividend Growth Portfolio  due to its enormous yield - currently 5.04%. An active buyback program is aggressively reducing the share count, and although the payout ratio is quite high, dividend growth can be slow given the high yield. Cigarette companies don't really need to invest very much back into the business, so nearly all of the free cash flow can go towards dividends and buybacks.

With the stock currently trading at $43.68, let's look for a strike price about 10% below that. This gives us an adequate buffer against a decline in price. The September $37.50 put option gives us a buffer of 14% with a premium of $74 per contract attached. If the option expires worthless the annualized return of this option is about 8.8%. If the price does fall below the strike price then you'd be obligated to buy the stock at $37.50 per share, with a cost basis of $36.76 per share factoring in the premium. At that price your dividend yield on cost would be 6%.

This situation is a win-win. You either get a 8.8% annualized return or you buy the stock with a 6% dividend yield. It's hard to go wrong with this one.

The king of bleach, charcoal, and water filters

Clorox is one of my favorite companies. Clorox operates a series of leading brands such as its namesake bleach, Kingsford charcoal, and Brita water filters, and it has maintained steady, consistent cash flows over the past decade. While net income has been roughly flat over the past ten years, share buybacks have driven a 6.7% annualized increase in EPS over that time.

The dividend has grown even faster than EPS, increasing by 11% on average each year. Although I expect this rate to slow in the future as the payout ratio has grown, I expect that Clorox will be able to comfortably grow the dividend at a high-single-digit rate annually. And with a yield of 3.4% after a recent 11% dividend increase Clorox is a fantastic dividend growth stock and part of my Ultimate Dividend Growth Portfolio.

Clorox doesn't quite have the same level of premiums as Lorillard, but they're still elevated given the high-quality nature of the company. The August $80 put option can be sold for $115 per contract and gives us a buffer of a little under 4%. If the option expires worthless the annualized return of this option is about 11.2%. If the price does fall below the strike price then you'd be obligated to buy the stock at $80 per share, with a cost basis of $78.85 per share factoring in the premium. The dividend yield at that price would be an impressive 3.6%.

If you told me that I could buy Clorox with a dividend yield of 3.6% I'd jump at that opportunity in an instant. Selling Clorox puts can make this happen.

Big oil, big premiums

Exxon is one of the largest oil companies in the world, with nearly $500 billion in annual sales. Exxon isn't my favorite big oil company, partially because it's so big that future growth will be difficult, but it's a consistent dividend paying stock nonetheless. The dividend yield is low compared to its peers at just 2.79%, and dividend growth has been too slow to justify buying Exxon at the current price. However, selling a put let's you pick your own price, so we can simply choose a strike price which would give us an adequate dividend yield.

One option is the September $85 contract. This comes with a $136 premium and a buffer of 6%. If the option expires worthless the annualized return of this option is about 7.1%. If the price does fall below the strike price then you'd be obligated to buy the stock at $85 per share, with a cost basis of $83.64 per share factoring in the premium. The dividend yield at that price would be a far better 3.01%.

I'd want at least a 3% yield to consider Exxon, and higher would be better. The $80 strike price, while lowering the annualized return to 3.5%, would allow you to buy Exxon with a dividend yield of 3.18% if the option were exercised. There's a trade-off here between the premium and the dividend yield, with a higher possible yield leading to a lower premium.

The bottom line

With volatility high put premiums for certain stocks are lucrative. If you're looking to buy a stock at a lower price than it trades for today consider selling a put option. You either collect a hefty premium or you get to buy the stock at your desired price. It's a win-win.

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Timothy Green has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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