Dividend Investing: Is It All It's Cracked Up To Be?

 If you are an investor, you probably already know quite a bit about dividends. In case you don't, we're going to explore the concept of dividend investing, discuss some key terms, and demonstrate how to create your own dividends. Because let's face the facts: getting 2%/year in dividend is not going to make you rich despite what you might read on the internet. Further, the arbitrage techniques you were thinking about (e.g. buying and selling on ex-dividend date) don't work.

A quick YouTube search will show 1,000 videos on dividend investing, but is it as valuable as you're lead to believe? Can you retire on fixed-income with dividends at 40?

In this post, I will demonstrate the reality of dividend investing vs. Theta investing, then talk about how we can do both at the same time to maximize our largely passive income.

tl;dr: Use options to collect premium while you wait for your dividend, being sure to avoid capturing the ex-dividend date prior to your contract's expiration. Choose reliable dividend companies with a solid history of payouts and growth.

Key Terms:

Let's make sure you can follow this post by discussing some key terms first.

Dividend: A cut of a company's revenue that it pays its shareholders for holding it's stock. Almost all of the time, a dividend is a cash payment. However, you will sometimes get a stock dividend in the form of shares, but these typically only happen during special dividends that we will discuss later. You'll only encounter stock dividends a few times in your life.

Dividend Yield:  The percentage of the stock's share price that is paid to shareholders in the form of dividend every year. For example, a company whose shares cost $100 that pays $2/year in dividend has a dividend yield of 2%. Since share prices change every day, dividend yield will change every day even though the actual dividend value may not.

Dividend Frequency: The rate at which a company pays a dividend. Most companies will pay a dividend quarterly (every three months). Some companies pay every month.

Ex-Dividend Date: The date on which new buyers will no longer get the next upcoming dividend. To get the dividend, you must complete your purchase before the ex-dividend date and hold it until the ex-dividend date. You can sell your shares on ex-dividend date and still receive the dividend. NOTE: on the ex-dividend date, the stock price will open down the value of the dividend unless another factor is involved since it last closed.

Record Date: The date on which the company's board gets notification of who holds its shares and are thus entitled to a dividend. The record date is after the ex-dividend date because trades take time to settle, and thus the company must await notification of who owned shares before ex-dividend date. 

Payment Date: The day on which the investor actually receives the dividend. It is not uncommon to wait a month between the ex-dividend date and the payment date. However, you can sell your shares any time on or after the ex-dividend date and still receive the dividend on the payment date.

Dividend Payout Ratio: The proportion of the company's profit that it is paying in dividend. If a company is making $2.20/share in earnings and paying a $0.50/year dividend, it is paying out 22% of its earnings as dividend.  Be cautious of companies that have payout ratios above 100% because it is an indication that it may not be making enough revenue to maintain its dividend payments. 

Special Dividend: Companies that wish to give back to shareholders in a one-time payment may do so with a special dividend. They are usually higher than regular dividends, and may come in the form of cash or, occasionally, shares of a company. Just like with regular dividends, expect the share price to open down the value of the dividend on the ex-dividend date.

How can dividend investing help me rake in gains?

Although I am about to trash talk dividend investing overall, let's start with an indisputable fact: dividend stocks will put cash directly into your account even if you do nothing. A portfolio built around dividends is great for people with little interest in actively managing their investments and prefer a long-term buy-and-hold strategy. Dividend investing will allow a passive investor to collect some level of income from his investments when he is sleeping. 

For that reason, you will often see popular YouTubers talk about how their dividends are going to make them thousands of dollars per year without doing any work, provided they start with $400K.

The above is an interest calculator from MoneyChimp. If you start with $400K and manage to get a 4% dividend rate (which is high), then you'd pull about $16,240/year before tax. Not bad for someone sleeping on a pile of cash.

But does the above investor sound like you? Are you the one Theta Gang investor who has nearly half a million dollars, does NOT play options, and is satisfied with 4% returns/year? For those of us who want to turn our money into a more worthwhile stream of income, we can do better. 

Being realistic about dividend returns

Ask YouTube about dividend investing and you will find that it is universally lauded. Terms like "passive income" sound wonderful. But let's rationalize our numbers here.

Let's say you start with $100,000 and want to start dividend investing. If you choose reliable companies that regularly pay dividends, you're probably looking at a regular return of about 3% per year. That's $3,000/year on a $100,000 investment. 

But let's not forget tax. Assuming your effective tax rate is a comfy 15%, that $3,000 is getting knocked down to $2,550.

$2,550 per year is $212.50 per month.

$212.50 per month is about $7 per day. 

$7 per day is enough for lunch if you don't get a drink. 

$7 per day for doing nothing is not terrible. But we can do better with a $100,000 investment. Let's explore how.

How to do better than 3% dividend in returns

We are going to manufacture our own dividends using options. Not only will this net us more than 4% per year in return, but it will allow us to trade any stock we went to and still convert our investment into a stream of income, even if the company does not normally pay dividends.

Let's look at Apple (AAPL). Looking at AAPL's dividend history, we can see that buying 100 shares for $28,835 will award the investor approximately $77 every quarter, or about $25 per month. Minus tax, this will equate to about $21.50 per month depending on your tax bracket.

That's fun gas money, but we can do better than just sitting and waiting for AAPL to pay us our dividend. Also note the next ex-dividend date. AAPL will likely go ex-dividend again in the second week of May, 2020. Keep this in mind in the next section.

Take a look at AAPL's options chain below:

If we set our expiration to just before the next ex-dividend date, we reveal a better picture. Selling a covered call at the $305 strike, which is 5.5% above the current market price, will award the investor $763.00 in premium, or $648.55 after tax.

That's about 10 dividends. That's 2 1/2 years worth of dividends from AAPL in 2 months. A dividend investor would receive $0 between February 25, 2020 and April 17, but those of us in Theta Gang have this opportunity to amplify our gains with this method. Further, we are not going to get assigned early because our call's expiration date is more than a few days prior to the ex-dividend date. We will only be assigned if our call is in-the-money.

Best case, our call is not assigned and we can collect the dividend and sell another call. 

Note: it is important to ensure the contract's expiration is before the ex-dividend date so we are not assigned early. Your covered call won't get assigned early if the ex-dividend date is more than a few days after the call's expiration.

Let's do another example from Motley Fool's Dividend Kings List

Apple is great stock, but you're probably not buying it for the dividend. So let's look at a dividend king: Proctor and Gamble (PG).

Proctor and Gamble appears to reliably go ex-dividend in the second or third week of April each year. Also note that it appears to increase its dividend by a few points each April as well. The next ex-dividend date will likely be the end of the second week of April, and accounting for its increase, will likely pay about $78 per 100 shares. That's $66.30 after tax. The payment date wouldn't be until May, but it's money in the bank after the April record date.

Let's sell a covered call with the ex-dividend date of April 3, 2020. This will give us some buffer before ex-dividend to ensure we are not assigned early.

The PG chain does not offer as much premium as AAPL. However, there is still a lot to gain here. While the dividend investor will receive $0 between now and April, the Theta Gang dividend investor can sell the $125 strike for $159 premium, or $135 after tax for an expiration date 6 weeks away.

Dividends pay out about $66.30 after tax per quarter, or $22.10 per month. Meanwhile, selling covered calls on top of that can bring us an approximately $45.00 post-tax "dividend" per month in the form of premium. Adding covered calls to our passive dividend investing more than triples our returns. And that's from an out-of-the-money covered call on a reliable dividend king.

What's the risk?

Every investment strategy has risk. In the case of manufacturing dividends, our risk is that our covered call gets assigned and we miss out on the dividend. In case of a stock like AAPL, that won't be a big deal because one premium payment is worth about 10 quarters worth of dividend. In the context of PG, it might be more problematic. Mitigate this problem by selling OTM calls. That way, even if you are assigned, you have gained money from the share's price increase as well.

Can I just buy a stock right before ex-dividend, collect the divi, and then sell? 

You can. But there is a problem here: on ex-dividend date, expect the stock to open down the value of the dividend. For example, if a $100 stock went ex-dividend on a $0.50 divi, it will open at about $99.50 if nothing else changed overnight. If you bought at $100 and looked to lock in a $0.50 divi payment before selling quickly, you'll be disappointed when you have to sell for $0.50 less than what you bought the shares for. It's as wash.

Can I take advantage of this by shorting shares right before ex-dividend so I can buy back cheaper when the market opens?

No, because if you are short shares on ex-dividend date, you actually have to pay your broker the dividend. 

Can I buy puts before a special dividend so that they will increase in value when the market drops on ex-divi, since I won't owe the broker the dividend because I didn't short shares?

Again, no. Options actually convert to special contracts for all contracts open through the special dividend's ex-dividend date. I tried this in 2015 when Pilgrim's Pride (PPC) offered an $8 special dividend. Believing the stock would drop $8 on ex-dividend date, I bought a put. I was devastated when I found out that the put contract that represented 100 shares somehow got converted to some "special contract" that represented 66 shares and $40 cash, or some bullshit like that. I called my broker, and he told me I was not as slick as I thought I was.

So, what does a proper Theta Gang dividend investor's portfolio look like?

Here is my preferred list. I recommend buying 100 shares of each down the line as you can afford, and then selling covered calls that expire prior to ex-dividend dates. Check  https://www.streetinsider.com/dividend_history.php?q=  for a good set of dividend history. Use your premiums and dividends to buy the next stock down the list and repeat.

1) QQQ: This is an ETF for the NASDAQ. Dividends are minimal at 0.78% as of today's market price. However, the strong premiums more than make up for it.

2) O: This is Realty Income, a real estate investment trust (REIT) that legally must maintain at least a 90% of its taxable income paid out as dividend. The company has paid a dividend every month since its inception and has increased it's dividend every quarter. It's premiums are not as heavy, but the dividend is reliable and pays frequently.

3) KO: This is Coca-Cola, a company we and Warren Buffet love. This is a good mix of dividend and premium, offering more than 3% in dividend and a moderate premium payout. Further, KO has increased its dividend regularly for almost four decades and has a payout ratio of almost 80%, representing its commitment to taking care of shareholders.

4) HD: Here is another Dow stock that offers a good balance of volatility for premiums and reliability from dividends. Today, HD announced a $1.50/quarter dividend, implying an annual dividend of $6, a yield of about 2.5%. This is also an increase of $0.14 from its previous dividend. HD carried a relatively low payout ratio of 23.6%, meaning there is more room for further dividend growth.

5) AGNC: Much riskier but more rewarding than the others on the list is AGNC Investment Corp. This is another REIT that must pay out 90% of its taxable income as dividend. However, AGNC invests in riskier assets than O, meaning its dividend is not as reliable. It's premiums are also comparatively low. However, it makes up for this by maintaining an approximately 10% dividend yield and has maintained this level since the end of 2015, although it has twice slashed its dividend by $0.02 each.

Summary

There is value in dividend investing. But since you are here, you know enough about stocks  and options to do better than pull $2,550 per year in income from a $100,000 investment.

Do Theta Gang things and pull premium in between dividend payouts and you will effectively manufacture your own dividends in addition to collecting from the company.

Keep in mind the risk of your covered calls being assigned and plan your strikes accordingly, and you should reliably be able to pull multiple years worth of dividends in the form of premium each and every year.

Disclaimer:

The above is a summary of Mikey's good-faith recommendations based on his investing experience and research. However, keep in mind that Mikey is not a financial adviser and every investor should do his own due diligence before making an investment. When in doubt, contact a licensed financial advisor.