Double Dipping Demystified

I’ve had a number of people ask about the concept behind “Double Dip Dividends”

A good place to begin, is here.

In a nutshell some stocks have a little bit of a disconnect between the option premium and share price during the period of time that they’re going ex-dividend. What happens is that a portion of the dividend reduction in the share price is actually incorporated into the premium, when by all rights it really shouldn’t be. In effect the premium is enriched by an amount that partially offsets the reduction in share price as a result of paying the dividend.

People that refer to efficient pricing in markets conveniently overlook the particular advantages that can be had with regular dividend payments.

Note that I said “regular” dividends. The concept does not apply to special dividends that are greater than $0.125/share. In those cases the strike prices are adjusted downward to reflect the distribution of a special dividend, while such adjustment isn’t made in strike prices for regular dividends.

When stocks go ex-dividend there are some guidelines that can tell you whether your shares are likely to be assigned early if they are in the money as trading closes prior to going ex-dividend.

 How far in the money are the shares?

The further in the money after deducting the amount of the dividend, the more likely they will be assigned.

 How much time is still remaining on the contract?

The more time remaining the less likely you will see early assignment.

 

Obviously there are less clear cut combinations, such as being deeply in the money, but having lots of time remaining.

For example, a handful of people reported early assignment of all or some of their Cisco shares this morning which closed at $23.43 Monday evening and was paying a $0.17 dividend.

After deducting the dividend shares were still $0.26 in the money, although there was risk that shares could have traded lower today. On the other hand there were 4 days remaining on the contract.

Beyond those factors are individual considerations, such as how much the individual holding contracts paid for the contracts and whether that person could make more money by simply selling his contracts versus exercising the contract, collecting the dividend and then either selling or holding the underlying shares.

Let’s look at JP Morgan, which is trading ex-dividend tomorrow (October 2, 2013).

For those watching such things you may have noticed that in the final minute of trading on Tuesday, JPM shares went up $0.09 to end the day at $51.95. If you had sold the $51.50 option expiring on Friday, the critical share price would be $51.88, since the dividend was for $0.38.

Everything else being equal, you might see early assignments at JPM prices as low as $51.88.

But let’s dissect the situation further.

Since the October 4, 2013 $51.50 call option has been trading the lowest price anyone paid for it was $0.39, while the high price was $1.20

With shares closing at $51.96 on the day prior to going ex-dividend it’s price will be re-set $0.38 lower to $51.58 as trading opens on Wednesday October 2, 2013. That $0.38 decrease from Tuesday’s close to Wednesday’s opening in the pre-market represents the dividend.

Currently, the $51.50 option bid at Tuesday’s close  is $0.47, which means that there is only $0.01 of time value, as the remainder is intrinsic value, as shares closed $0.46 in the money

Remember, just yesterday we sold calls at $0.52 when shares were trading at $51.65 ($0.15 intrinsic value, $0.37 time value). A portion of that time value was due to the dividend of $0.38, however at a share price of $51.65 no rational person would exercise early to get the dividend and end up holding shares the following morning priced at $51.27 that he had to pay $51.50 to obtain and also paid a premium to purchase the options.

So from an option holder’s perspective when would it make sense to exercise the option early?

Assuming you can sell the shares for $51.58 tomorrow morning that represents an $0.08 profit from the $51.50 strike price that they paid when exercising. Add to that the $0.38 dividend to get a total of $0.46 profit.

But the lowest anyone paid for the right to do any of this was the $0.39 option premium meaning that there would be a potential for only $0.07 profit for those that timed it just perfectly.

But that profit margin, available only to some of those having bought options assumes that shares will open at least at $51.58 or higher. What the person considering the early exercise thinks about is also what is the chance that once I take hold of shares it will go down in value before I have a chance to sell the shares? Is it worth the $0.07 profit or even less?

The closer the opening price will be to the strike price the greater is that likelihood, which means taking a loss on the shares in which they just took ownership. On top of that is the cost incurred in having to purchase shares. Remember that option buyers typically  find great appeal in leveraging their investment, perhaps by 10 times or more. They don’t get much delight in buying stocks, even if only for minutes, if it means introducing portfolio risk and only getting 2x leverage.

So while JP Morgan essentially closed $0.08 in the money that makes it a risk factor for early assignment.

But there are still 3 days left on the contract. That argues against assignment.

After that it becomes luck of the draw. How much did your contract holder pay for his contracts? Anyone who paid  more than $0.46 for their options would have been better off closing their position by selling the contract for $0.47 than to exercise early.

The likelihood is that there are more options holders who purchased their options at prices greater than the low point of $0.39, so the number of individuals in a position to rationally act and exercise early would be relatively small.

My expectation is that most people will not be subject to early assignment, but I did find the last minute surge in share price very curious and made me wonder whether it was related to the ex-dividend date.

Occasionally you will also see early assignments that are completely irrational and less occasionally not see early assignments when they would have been completely rational. You can be certain that those were always products of an individual investor. While one is maddening, the other can be a nice surprise..

For those wondering about Cisco, the lowest price paid for the October 4, 2013 $23 options was $0.20. If selling shares at $23.26 that would have represented possibly a $0.26 profit (if shares didn’t head lower), plus $0.17 dividend, minus $0.20 option premium paid yielding a potential $0.23 profit per share. Of course the high price paid for option contracts was $1.18. For those paying anything more than $0.43 for their options they would have been better off simply trading out of their position and closing their option rather than trying to capture the dividend and assume the risk of ownership.

While having early assignment can sometimes be frustrating, especially when there is a last day surge in share price, as occurred with Dow Chemical last week, when able to capture both the dividend and a premium enhanced by the pricing inefficiency it is a thing of beauty.

 

Wednesday Morning Postscript:  The first thing I do on ex-dividend mornings is to check to see whether I still have all of my shares. In this case the JPM shares have stayed intact. For anyone who decided to exercise their options the pre-market is indicating a loss of $0.27 bringing shares to $51.31. Suddenly, the thin profit that a small portion of option buyers deciding to exercise thought they had last night has become a paper loss and they would find themselves regretting the decision to exercise for the sake of securing the dividend. Holding the security for a option buyer means that at least $2575 of his money is now tied up and possibly generating margin interest costs and is unable to be further leveraged in order to buy more option contracts.

Most rational contract holders would have considered that possibility very strongly before making the decision and would likely have opted to not exercise, as a result.

Ellison Fiddles While Oracle Burns

Maybe I belong to a different generation, but I have certain expectations regarding behavior and responsibility, especially when other’s are your subordinates and maybe even extending to your shareholders.

As a short term holding I’ve always looked to Oracle (ORCL) as a potential addition to my portfolio that relies on the use of a covered call strategy.

While I have often thought of buying Oracle shares, in 2013 I’ve only done so twice, this most recent occasion being in advance of its earnings report. In hindsight, however, I wish I had done so much more frequently because of how mediocre its price performance has been.

As a covered option trader I like mediocrity, at least when it comes to share price. That’s the perfect price behavior to be able to buy shares and sell calls or simply sell puts and collect premiums, sometimes dividends and sometimes small capital gains on shares with relatively little fear of large price swings downward. With little movement in underlying shares you can do so over and over again.

Oracle was truly perfect, that is of course, as long as you ignore the two earnings reports prior to Wednesday evening’s numbers being released.

Any company can see its shares tumble after releasing earnings or providing guidance. In fact, it doesn’t even take bad numbers to do so. All it takes is for disappointment or unmet expectations to permeate the crowd. After all, the saying “buy on the rumor and sell on the news” got its start in the aftermath of what would seem like paradoxical behavior from investors.

So I think a company can sometimes be excused for what happens to its shares after earnings.

What I have a harder time excusing is the excoriating finger pointing that came on that occasion six moths ago when Oracle shares plummeted in what appeared to be a company specific issue, as its competitors didn’t fair as poorly in their reports and didn’t suffer similar market misfortunes.

Larry Ellison, the CEO, blamed his salesforce for the quarter. He cited their lack of urgency which allowed third quarter sales to slip into the fourth quarter. I don’t really now how Oracle’s sales force is compensated, but deferring sales is not a typical strategy.

When the next earnings report was released this time Ellison blamed Oracle’s performance on the poor global economic environment, stating “It was clearly an economic issue, not a product, competitive issue,” during the ensuing conference call. That, of course, despite the fact, that once again the competition seemed to not experience the same issues. I guess those sales that previously had been said to slip into this quarter remained slipped.

Surely they would show up for the next earnings report.

AS CEO it’s probably easier pointing fingers at others. That’s certainly the strategy that ruling despots use when there’s a need to deflect criticism or place blame to account for the wheat crop shortage.

At the very least Ellison has at least been visible, perhaps too visible. The world learned of his purchase of 97% of the Hawaiian island, Lanai and wondered at that point whether his attention would be diverted from the job of running Oracle, notwithstanding the presence of its President, Mark Hurd.

He was all too visible recently when referring to Google (GOOG) CEO Larry Page as “acting evil” and questioned the ability of Apple (AAPL) to survive in the absence of Steve Jobs.

In a way, perhaps that kind of presence is preferable to the CEO that fails to make any statements following tragic events on one of his cruise liners, not once, but on two occasions. Maybe Ellison won some new customers over with his goodwill.

But here we were, on the day that Oracle was primed to report earnings yet again. For my money, and I did buy shares on Monday, it was inconceivable to me that someone with as much at stake, especially on a reputational level would allow a third successive disappointing report. Whether by slashing costs, financial optics or perhaps by virtue of those sales that slipped from one quarter to the next and then to this one, I was certain that there would be no repeat of the embarrassing price slides the last two times.

Funny thing, though.

Instead of being an integral part of the earnings report and guidance, Larry Ellison was cheering on the crew of Oracle Team USA in a losing effort at today’s America’s Cup race.

Again, call me old fashioned, but I like to see my CEOs involved in what may have a substantive effect on my fortunes.

The good news is that Oracle didn’t have a meltdown after reporting its earnings. In fact shares went higher until reversing the course when the conference call started and the new disappointments were made known, including guiding significantly lower growth than had been expected.

To give Ellison some benefit of the doubt, perhaps he knew that the initial response would be relatively muted and his presence was unnecessary. Besides, was he going to be able to have credibility going back to the well again and blaming macroeconomic business conditions?

Not with me, he wouldn’t.

With two days to go until expiration of the weekly options I had sold I expect to be able to extricate myself from the position relatively easily and show a profit for the effort.

In all likelihood I’ll also look for any other opportunity to purchase shares because sometimes mediocrity is the gift that just keeps giving. As long as Ellison will be fiddling and paying attention elsewhere, I don’t mind an Oracle that simply treads water and stays in place, although I’m sure that the Larry Ellison of old would never have accepted or allowed that kind of an existence.

Herb Greenberg, of TheStreet.com is once again soliciting nominations for the worst CEO of the year. As far as I know the rules don’t exclude absentee CEOs. While Oracle is only trailing the S&P 500 by approximately 19% YTD and is certainly performing better than other companies with less than capable management, the shame factor is worthy of your vote.

I Bought Apple

There are some people that just love to take in wounded birds and believe that somehow that can nurse the poor wounded creature back to health. For some sainted few that is their “raison d’etre.”

I bought shares of Apple (AAPL) this morning after it was wounded by downgrades from Bank of America (BAC), UBS (UBS), Piper Jaffray (PJC) and Credit Suisse (CS).

You’re welcome, but I’m not saint. I certainly can’t be categorized as an “Apple lover.” Neither the products nor the shares have had consistent appeal for me, but the subjectivity is out of place when it comes to capitalizing on opportunity.

Clearly, this opportunity stems from the high profile downgrades. Such downgrades confirm for me that there is greater value placed on not missing out on potential gains than there is in protecting portfolios from disappointments.

Recent history has not given strong indication that Apple shares will rally after product launch events, particularly as the quality of the leaks regarding the “news” seem to get better and better. There are few, if any, upside moving surprises. In fact, one wouldn’t be terribly far off base to suggest that the sum total of predictions of what will be announced easily exceed the capability of squeezing all of the new options into a single device. As a result there is always bound to be someone leaving the party disappointed.

For those further expecting the announcement of new relationships, such as in China, there has to be some thought that the downside to disappointment may likely exceed the upside of what may already be partially built into the price.

Yet, protecting a client’s assets takes a back seat.

My basic understanding of math tells me that it’s more difficult to recover from a $5 loss than it is to find an opportunity to make $5 in place of the opportunity you missed.

But with a short-sighted view of what the future holds, analysts have created opportunity, just perhaps not for their clients.

I almost never buy shares without concomitant sale of option contracts, but in this case I listened to my own advice from just a few weeks ago when Carl Icahn entered into the picture.

In addition to now having a more favorable entry point to re-establish a position that was recently assigned, so too does Apple find itself in a better position to further implement its buy-back program. There’s no shortage of money still unspent in that program and there may be more added to the bucket.

No doubt this will be a topic of Icahn and Tim Cook’s upcoming dinner, which Icahn confirmed a few days ago would be this month.

But now that the product offerings are well known, they have no doubt been dissected by many who can extol or pan the virtues and relative value of the innovations. To attempt to analyze the advances incorporated into the iPhone 5c and 5s is somewhat meaningless with regard to short term investing, which is all I hope to ever do.

What I hope to do is turn shares into short term realized profit vehicles. For that reason I don’t dwell on the possibility that the fingerprint reader may be an entry way into mobile secure commerce solutions.

What I dwell on is how likely is Apple to withstand this onslaught and then I’m likely to sell call options into price strength, as I expect a bounce in shares, particularly as Syria is temporarily off the table.

Apple will continue being an incredible cash machine with these new devices. Argue about their price points as much as you want, argue about cannibalization, too. The reality will be that the phones will fly off the shelves and tie up the consumer base for another year or two. After all, it’s not just about selling product, it’s also about making certain that your consumer base is effectively barred from going to the competition without the burden of additional cost.

I’m still a product holdout, but the rest of my family isn’t, some of whom only joined the parade this week.

Scoff at the superficial changes, but Apple knows better than most others that bold colors will not only drive new sales. but will instantly help distinguish itself in the hands of one adolescent as another is watching.

While everyone enjoys talking about “the big picture,” today’s downgrades and market reaction have been anything but mindful of that more encompassing view.

This is what opportunities are made of, despite the fact that risk shares the same parent. Having been very critical of Apple over the past 15 months, and questioning why people had not taken profits before they evaporated, I’ve nonetheless found a number of opportunities over that time to re-establish short term positions. In the past the drivers of those decisions were predominantly based upon option premiums and dividends. This time, however, the catalyst is share appreciation as the market will realize that its immediate reaction was unwarranted.

Microsoft: What Would Munger Do?

For a company that many have said represents nothing but “dead money,” Microsoft (MSFT) has certainly been up and kicking lately.

Fresh off the post-Ballmer resignation news and subsequent rally, Microsoft shares gave back everything in this day’s trading, as it announced plans to purchase its smart phone partner, Nokia (NOK).

Nokia itself is no stranger to having been left for dead, as it’s one-time dominance has seen it eclipsed by Apple (AAPL) in sales, and by others in perceived technological prowess.

In executing a purchase of Nokia it also started speculation that they were in effect “buying” their one-time employee, Stephen Elop, most recently CEO of Nokia, as a prime candidate to be Ballmer’s successor.

I say “most recently” because Elop has stepped down as CEO of Nokia so as not to give the appearance of Nokia actually being the superior party in the deal, in the event that Elop becomes Microsoft’s new CEO.

While Berkshire Hathaway (BRK.A) has no current position in Microsoft, the ties between their founders, Warren Buffett and Bill Gates, respectively, is well know and runs deep, much like a river, which is coincidentally the origin of the name “Nokia.”

Buffett’s less known partner, Charlie Munger, who is almost 90 years old, is rarely in the public eye. He is, however, a legendary investor who takes a back seat to no one. When asked the secret to his success his reply was simply “I’m rational. That’s the answer. I’m rational.”

Today, that seemed to be in short supply, as news came out of Microsoft’s $7.2 Billion deal. The immediate reaction in share price was to drop market capitalization by about $17 Billion.

That seems irrational, perhaps as irrational as a similar increase in market capitalization barely a week ago when Ballmer announced his plans.

WWMD? What Would Munger Do?

For me, that was reason to purchase shares, just as Ballmer’s resignation announcement was reason to sell shares. I was willing to pick up new shares had Microsoft fallen back to $33, never expecting an opportunity to occur so quickly in the absence of a general market meltdown.

As with most of my holdings the Microsoft shares were covered with options. In this case the $33 strike price was eclipsed, but buying back the options at a loss was rational, because the share price accelerated more than did the “in the money” premium. In those rare occasions that I do that, I always sell the shares as soon as the options positions are close. To do otherwise invites the possibility, or with my lick, the probability that the underlying shares will drop just as quickly as they rose, thereby making it a losing proposition all around.

Of course, you might also make the case that you wouldn’t have expected a major deal, such as this one to have occurred under the leadership of a lame duck CEO, but Microsoft is no ordinary company and Steve Ballmer is no ordinary CEO. Whatever talk you may hear about “the law of large numbers,” there is no denying that those large numbers allow you to act with a certain amount of impunity and have a greater long term vision.

That’s the rational thing to do.

Tellingly, the decision to consummate this deal was made without informing ValueAct Capital Management of the decision. The activist shareholder was just informed that they would be receiving a seat on the Board of Directors, but they were not in the loop on this deal. Besides, how rational would it have been to let a 1% equity stake get in the way?

However, even if the Nokia purchase follows in the path of other Microsoft initiatives and its purchase is written off in its entirety, the $7 Billion purchase price is of little significance to Microsoft and presents a far less liability than it seems on the “Surface,” which is in its own liability category.

To start, the funds for this purchase are from cash held overseas. Unless there is a sudden change in United States corporate tax laws, those funds sit idly, reducing the Price to Earnings ratio. The only use for the funds is further overseas investment. The $7 Billion being spent on Nokia represents approximately 10% of Microsoft’s overseas cash. Even if Ballmer goes on a wildly drunken global spending spree it would be incredibly difficult to make a dent in that overseas pile.

For their money Microsoft escapes US taxes and receives tax advantages related to the purchase. The taxes saved alone are approximately $1.5 Billion had they repatriated the money. Additionally any expenses incurred in the United STates further reduce tax liability.

But there is more to the deal to offset the cost that just financial optics and tax engineering. The margins on Lumina units will jump from approximately $10 for software royalties to $50 for hardware. With a projected sale of 30 million units net revenue just increased by $1.5 Billion. Again, in absolute terms that’s not much for Microsoft, but relative to the cost of the Nokia purchase, it is substantial.

What is clear is that what we now think of as smart phones, in some form or another, will evolve into our personal computers. Without a strategy to be part of that evolution money in the bank is insufficient to ensure continued relevance.

Google (GOOG) gets it and secured their foothold with Motorola, a cell phone manufacturer that had also seen better and more heady days, but with a great patent portfolio. Microsoft is now making a commitment to go down a similar path and also securing potentially valuable patents along with the manufacturer of 80% of the Windows OS phones on the market.

I’ve long liked Microsoft because of its option premiums when utilizing a covered call strategy and its recent history of dividend increases. The company is widely expected to announce yet another dividend increase, but even at its current rate of nearly 3% it is far ahead of the mean yield for S&P 500 companies, even when considering only those that pay dividends.

WWMD?

It would be presumptuous to pretend to know, but Microsoft at the currently irrationally depressed level appears to be poised to out-perform the broad index and is preparing itself to leave behind its reactive ways for what we all know to be a lucrative communications market.

Just ask Verizon (VZ).

Disclosure: I am long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may add additional shares of MSFT

Dividends

I received a very nice text message from a subscriber this morning.

I think that if I’m ever in the market for a publicist for Option to Profit, my search need go no further.

His message, in its entirety was “Option to Profit: Come for the premiums, stay for the dividends.”

My guess is that he’s been seeing a stream of dividends coming in lately. Today alone had Lorillard, Weyerhauser and Molson-Coors.

Some of you know that I have mixed feelings about dividends and am not really a big fan.  (I Don’t Understand Dividends and The Myth of Dividends) but as long as there appear to be some pricing inefficiencies in option premiums when dividends are about to be paid (Double Dipping Dividends), why would you want to pass up that opportunity?

I’ve been increasingly putting an emphasis on dividends as market volatility has declined, in order to increase over all yield and I have to admit that I don’t mind receiving those brokerage alerts telling me when a dividend check has been deposited into my account (Dividends? Forget DRIP and Go PRIP).

Because of my belief in attempting to exploit those pricing inefficiencies when they appear is why I send out queries on ex-dividend mornings for those positions that were in the money at the time of going ex-dividend. It’s all about collecting the data and validating the strategy and the information that so many of you regularly provide is very helpful and appreciated.

I’ve been looking for a good way to express the OTP portfolio’s dividend yield for a while but it’s difficult to really get a good fix and one that accurately depicts the reality, especially if seeking to project annual return.

Since I like to compare everything to the S&P 500 Index, it makes sense that I do the same for dividend yield.

Currently the average S&P 500 stock offers a 2.06% dividend yield. However, that is impacted by the 82 stocks in the index that pay no dividends.

So for the 412 dividend paying stocks in the index, the average yield is 2.46%. In 2012 the average dividend paying stock had a 2.7% yield. The current year’s lower yield reflects generally higher stock prices.

If you look at the Weekly Performance spreadsheet you may have noticed for the past two months or so some calculations on each page that assesses dividend yield of open positions and projects that yield on an annual basis.

I had not been planning on saying anything about those spreadsheet scribblings until the end of the year, until having received this morning’s message.

The good news is that with increased data collection the model for creating projections is beginning to resemble reality.

The better news is the reality.

The dividend yield for positions closed in 2012, all 272 of them was 2.9%

Thus far the yield for positions closed in 2013 is 2.7%

Both of those reflect all positions and not just those paying dividends. As a result the gap is 0.7% and in a very favorable direction.

At the moment, not including new purchases this week, the remaining open positions in the OTP portfolio are delivering an annualized dividend yield of 2.9%, again that includes both dividend and non-dividend paying positions.

For those that are a bit more traditional than I am and have long appreciated dividends I finally see your perspective as those account credits have been adding up.