Utility stocks have been hit hard of late, dropping nearly 7% during the past two weeks to push the dividend yield on the Utilities SPDR (XLU) to more than 3.5%.
The decline erased part of this year’s gains, but the XLU is still higher by nearly 8% excluding dividends for 2014. Nonetheless, there still might be additional downside risks to the utility sector … so if you are interested in grabbing dividends from utilities, you might want to consider a naked put, which can amplify the sector’s dividend power.
Naked Put Strategy
Buying puts gives you the right (but not the obligation) to sell a stock at a specific price on a given date. If you sell a put option, however, in exchange for the premium you receive for selling the option, you have the obligation of buying the underlying stock if the person who bought the put uses his right to sell the stock.
A “naked put” gets its name from the fact that you’re not hedging your risk with another security — a hedge in this case might be a short sale of the stock, or the purchase of another option, to counter the event in which you would have to buy shares at the strike price.
In short, you sell naked puts if you believe the price of the security won’t move lower, and/or if you’re willing to buy the security should it fall lower and hit the strike price.
Why is this good for income? Because the premium received from selling naked puts allows you to enhance the overall income received from holding the XLU.
For example, XLU Sep $40 puts are currently trading at 75 cents per contract. This means for every contract sold (each contract is 100 shares of stock), and investor will receive $75. The September contract expires on Sept. 20.
The XLU is currently paying a quarterly dividend of approximately 37 cents per share, and has an approximate ex-dividend date of Sept. 23, 2014 (based on prior dividend date). Thus, if the price of XLU sits below $40 per share (the strike price) on the put’s expiration date, you will have to purchase the stock at $40. If you hold XLU through the ex-dividend date, though, you’ll also receive a dividend payment of 37 cents per share.
The combined payment of the option premium and the dividend payment would be $1.12 — more than three times the normal dividend payment.
Click to Enlarge Using a number of technical analysis tools, you can evaluate sentiment. The 200-day moving average (red line) might be a prudent place to purchase the XLU. Over the past two years, the XLU has remained above or near the 200-day moving average except for a brief period when it dropped $1 below in late November of 2012.
Additionally, the RSI (relative strength index) — which is a momentum oscillator that measures overbought and oversold levels — is moving higher and printing at 33, after recently dipping below 30 the oversold trigger level, which is a bullish sign for the ETF.
Assuming the 200-day moving average holds, you will be able to sell an XLU $40 put and receive a dividend yield of 2.8% ($1.12 /$40) for the quarter (11.2% annualized).
The risk on a naked put strategy is that the stock continues to tumble lower — here, you would be obligated to purchase the XLU at $40 even as it continues to drop. A prudent technique is to have a stop-loss level in mind where you either repurchase the put or sell the stock if you have already taken delivery from the put sale.
Since you are looking to earn $1.12 from your premium and dividend combined, by late September when the dividend is paid, you could consider risking a similar amount ($1.12) on the trade. The breakeven price from the sold put is $38.88 ($40 the put strike – $1.12), and if you lost $1.12 from the breakeven price, the price to stop out of the trade would be $37.76 ($38.88 – $1.12).
If the price of XLU does not reach $40 (put strike) by the expiration date of the put option (Sept. 20), you will keep the premium of 75 cents, which is double the dividend you would receive if you purchased the XLU.
As of this writing, David Becker did not hold a opsition in any of the aforementioned securities.