How to buy Dividend Stocks at a discount

In my last hub I tried to articulate the many reasons for investing in dividend paying stocks. In summary, dividend stocks are subject to less fluctuation, have a history of appreciating in value, and offer tax advantages over other income vehicles.

Dividend paying stocks are not a sure thing, but the odds of having success are much more in your favor.

I love dividend paying stocks. My retirement is going to be funded by the dividends of large, profitable companies. And while the temptation may be to get into those stocks at whatever the market price is at a given moment, I have as a part of my investment discipline a willingness to get them at a discount.

I do that by selling what are called "puts" on a stock I would like to purchase. I put is a contract that allows the buyer of the put to sell you 100 shares of a stock at a set price. So for example, say XYZ stock has a current market price of $25 and you think it should continue to pay out dividends for the foreseeable future.

The way most people would go about buying XYZ stock would be to pay $25 a share for the stock and start collecting (and I hope reinvesting!) the dividends. But you don't have to be most people. You can choose to sell someone a put on XZY stock. In this hypothetical example for XYZ stock, you would sell someone the right to force you to buy XYZ stock to you any time over the next 60 days at a price of $23. And in return for taking on that risk you are paid a preimum.  For our example we will say .30 a share.

Why would someone buy a put from you? Why would someone pay you money to sell you stock for less then it is trading for at the time? Most people buy puts to protect their gains from a market crash.  Think of it like someone purchasing insurance from you. So in my hypothetical case the person who purchased the put from you might want to protect his gains as his price has appreciated from say $18 to its current $25. If bad news hits the market the stock may drop back to the $18 or the below the price it was purchased for. But the put buyer protected most of his profit and sold his stock, to you, at $23. 

So you can see the downside in my example quite clearly - you just paid $23 for XYZ that is now trading at $18 down $5 a share from what you purchased it at on your option being exercised. But on the plus side, had your purchased at $25 like you were tempted to you would be down $7 a share and not collected the put premium.

1. Identity the stock you want to buy. This step would seem to be a given, but at the same time it is not always easy to identify what dividend paying stock you want. If you are starting out I would recommend one of what is called the "Dividend Aristocrats." Dividend Aristocrats are companies that have a track record of paying and increasing the payment of their dividend for 25 or more years. If you are just getting started, you also might look at an ETF that tracks only dividend paying stocks. You can sell a put on an ETF, though I have found the volume to be lighter on this type of ETF so your premium won't be quite as high. But, if you are just starting I would suggest going ahead and sacrificing a little premium in return for the safer investing of a dividend paying ETF.

2. Wait for a dip. Yes, that's right, wait for a dip! As a stock is decreasing in price the value of a put option premium goes up! So if you identified XYZ stock at 25 as one you want, you are going to sell the put at $23, wait for a day when the stock is dropping to sell your put. As the price of the stock is closer to your put option strike price, you receive more of a premium. So sell your put option on the day a stock has fluctuated to say $24.

3. Sell the put. Okay that one is pretty strait forward. Go to your discount brokerage and enter your sell order on the put. And remember you need enough cash in your brokerage account to cover the cost of buying the stock should your option be called out. So in my example of XYZ stock you would need $2300 plus money to cover the commission your brokerage charges.

4. See what happens and be prepared to change direction. Now it is time to watch the price of the stock you have a put option out on. Given normal fluctuation it would not be surprising to see it dip to the level of the strike price over the time period of the option. But if you are selling a put say 60 days out on a stable stock, it will also likely go above the strike price, too. However, if something drastic happens you may want to prepare yourself to exit your position. As an example, some drastic news could hit the US economy and stocks start dropping right and left, including your dividend payers. At that point you may choose to buy back your put option at a loss. In other words, you may have to pay more to get out of being insurance to another stock holder then what you sold the policy for, but if things are really tanking it may be a small price to pay.

5.Repeat the process or start collecting your dividends. Should your stock stay above the strike price when the option expires, you get to keep the premium you received for selling the put option and you don't own the stock. (additionally, it is possible though not likely, the price of the stock will be below the strike price of of the option and you still will not be called out and forced to buy the shares of the stock.) At this point, if I don't own the stock, I usually choose to sell another put option on the stock I want to purchase and collect another premium for selling it.  On the other hand, if you do end up with the stock, know that selling the put option allowed you lower the effective price of the stock a little more and you get to start collecting and reinvesting the dividends a little sooner.

Sure!  If XYZ stock stays above 23, the put you sold will expire worthless. In theory, should you repeat this process 5 more times at the same price and the stock never drops to $23, you will end the year making $1.80 a stock on a stock you never owned! That is a 7.2% return on the $2300 reserve required with many brokerage accounts. This is higher then the initial yield of any dividend paying stocks a prudent investor would chase for long term dividend growth.  However, over the long term, companies that continue to pay out and increase their dividends will overshadow a 7.2% return - and with favorable tax treatment.  I use this strategy to get into stocks I want at a discount, not to generate income over the long term.

Stock and option investments can and do lose value. Please consult your investment adviser before starting down the dangerous though potentially lucrative world of selling put options and owning dividend stocks.