Why Option Premiums Could Be Better Than Dividends
Tax-filing season has come and gone. Hopefully it went smoothly for all of you. Part of the cost of investing, of course, is to give Uncle Sam his cut if you make money.
The IRS wants to know how much you received in dividend and how much net gains you realized during the year. This is because the two ways to make money on an investment are dividend and capital gains.
Capital gains are considered either long term or short term. Long-term gains are generally taxed at a lower rate. Dividends are also divided, into qualified and ordinary dividend. Qualified dividends are taxed at between zero and 20%, depending on your income bracket, and ordinary dividends are taxed at your marginal income tax rate, which ranges from 10% to 37%.
Dividends from most U.S. companies are considered qualified if you hold them for at least 61 days during a 121-day period centered around the stock’s ex-dividend date. In other words, the counting period starts 60 days before the ex-dividend date, and continues for 60 days after the ex-dividend date. If this sounds confusing, keep in mind that for a company that pays dividend every quarter, if you hold the stock for at least two months, chances are the dividend will be qualified.
Option Premiums Tax Implication
I’ve talked about selling options and compared collecting the premiums to receiving dividends before. A big difference between an option premium and a dividend is that your gain/loss from writing an option is considered to be a capital gain or loss.
Since most option trades will be for under one year, any gains on the option premiums will be taxed as a short-term gain, usually at a higher rate than a qualified dividend. Does this mean dividends are superior to option premiums? Not necessarily.
For very conservative investors content to sit back and collect quarterly dividends, it’s fine to be passive. But for more aggressive investors who want to squeeze out more out of their portfolio, selling options is a choice to seriously think about.
Here are some reasons why selling options can be considered superior to dividends.
In the case of a dividend, you are a passive receiver. After you buy a stock, how much dividend you will receive is entirely up to the company. Sure, you do have a vote if the issue of dividend is put to a vote, but unless you are a significant shareholder, you essentially have no control.
However, when you sell options, you can decide exactly how much risk/reward you want to take on. For a typical liquid stock, there is a wide range of different options you can choose from in terms of strike price, expiration date, and the size of the premium. You can also use combinations of options to manage your risk. Options simply offers tremendous flexibility that dividend cannot.
In the case of covered calls, you can also add option premiums on top of dividends you are already collecting. For example, let’s say you own 100 shares of a $50 stock that pays $0.25 per quarter. Every three months, $25 is deposited into your account. In one year, you collect $100 in total dividend from the stock.
Let’s say you are able to sell a $52 call against the stock that will expire in three months for $1. Your quarterly income is now suddenly $125 instead of only $25. Hypothetically, if you are able to sell the covered call 4 times in one year for $1 each time, you would generate $400 in additional cash flow (ignoring the negligible commission).
Of course, the risk is that the stock could be called away. To reduce seller’s remorse, pick a strike price at which you would be comfortable selling the stock anyway.
Getting Paid to Wait
Options also allow you to take advantage of a falling market. One way to do that is to sell puts against stocks you like at below-market strike prices. If the put expires worthless, you can rinse and repeat. Even if the put is exercised, you get to buy the stock at a lower price than before. To reduce buyer’s remorse, pick a strike price at which you would have bought the stock anyway.
This doesn’t mean that dividends are no good. Quite the contrary. Dividend and option premiums together can boost the cash flow by quite a bit in your portfolio.
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