Power To The Elbow

Yesterday, we asked if Realty Income was a sound investment despite the challenges of high interest rates and possible client defaults. You can read that article here.

Today, let’s dig into three different ways we can trade NYSE – O stock. The first is the most straightforward. We will buy the stock and collect those sweet monthly dividends until something changes that would make us think that the dividend is in danger. Second, we will sell an out of the money put at a strike price that we are more comfortable buying it at. Finally, we will look at selling a short put spread to minimize our downside risk. 

Strategy 1: Buy the stock and collect the dividends

The trade: Buy 10 shares at $50.00 for a total investment of $500.00 + commission.

Although this appears to be the simplest strategy, it could potentially have some of the worst consequences. These risks are:

The risk free interest rate might increase causing the relatively risker dividend income from Reality Income to be less attractive. Currently the 10 year treasury rate is at 4.78%. The dividend yield for Realty Income is 6.08% leaving a premium of just 1.3%. This means that if the stock price falls more than 1.3% in the time you owned this stock, you were better off just buying the safe 10 year bond instead. A 1.3% drop is only 65 cents. O traded between 49.18 and 50.42 just today. Less than one day’s fluctuation in price is not enough of a margin of error for me.

Strategy 2: Sell out of the money cash covered put

The trade: Sell 1 Nov. 17 Put at 47.50 for 50 cents. Collects $50 in premium but will cause us to buy 100 shares for $475 if the price falls below 47.5 on Nov. 17.

We are selling an out of the money put that is more than one month away from expiring. We would do this if we are not convinced that this stock is done going down but we would like to own it at a price $2.50 lower. If it does not go down below the strike price, we get to keep $50 of premium. This strategy would earn us more cash than the dividend paid and would lower the cost basis if we were forced to buy the shares at 47.50.

This strategy still has some downsides. First, if we end up buying 100 shares at 47.5, our dividend yield going forward would be 6.5%. It is better than the first scenario, but still not much margin for error. This makes the downside risk still just as valid as before. Also, if the price increases, we will not benefit from any of the positive price action. 

Strategy 3: Sell a short put spread

The trade: Sell the Jan. 19 put at 50 for $2.50. Buy the Jan. 19 put at 47.50 for $1.30. Collects $1.20 in premium with a max loss of $2.50 per contract sold.

This trade would cap our downside risk of stock price drops.The most you could lose is $120. That is the equivalent of the stock price going down to $38 in the first scenario. It would also collect .53 more in premium than you would collect in dividends in the same amount of time if the price doesn’t go down below $50.00

Unfortunately, like the second scenario, this option also has a big opportunity cost to the upside. When we sell a short put spread and the stock price goes up, we will miss out on all the gains generated by the increase.

Would you trade this differently than one of the three options? Let me know in the comments.

Summary

If you have strong conviction that the price is going up and you love collecting dividends, the first option might be best.

If you have strong conviction the price will stay flat or increase for the next two months but if it falls you wouldn’t mind owning it for the long term, the second option might be best.

If you are worried the price might fall dramatically if a particularly unlikely thing happens and want to cap your losses, the third option might be right.

The best part of investing is that you don’t have to choose any option if it isn’t 100% right for you right now. It is better to wait for a trade that is in your sweet spot rather than trade just to trade.

Which option do you think is best? Let me know in the comments.