Pecuniam apparatus perpetuus — the Perpetual Money Machine

Dividends are great, but ... can we do better?

If you're reading this, then I probably don't have to sell you on the concept of a dividend paying stock. If you get a good one, it even continues paying dividends right through a pandemic!

My current favourites are The Canadian Imperial Bank of Commerce (CIBC), trading under the symbol CM on the Toronto Stock Exchange (TSX), and The Bank of Nova Scotia (trading as BNS), so I'll use them in the examples here. (CIBC currently pays $1.46 per quarter, and BNS $0.90 per quarter. Using today's stock prices, that amounts to 5.7% and 6.6% per year.)

If you intend to hold these stocks “forever”, then what I'll show you below will allow you to make more money than just what the dividends can bring in. Best of all, it's completely safe — there's no more risk with this approach than there is with just holding the stock forever.

A small bit of background first...

We're going to use a derivative instrument called a “covered call” in order to work our magic. See my other article for detailed explanations and examples.

So, this is actually pretty simple. Let's say you own 100 shares of CIBC, and for easy calculations you bought them at $100 each. That's $10k of your nest egg we're talking about.

If you did nothing, the stock would generate $1.46 per quarter, and in a year, you'd have an extra 4 x $1.46 = $5.84 per share. Given that you have 100 shares, you'd have an extra $584.00 in your account.

You can, however, enhance your income by writing a covered call. There are three characteristics to the covered call:

The expiration:

All good things must come to an end, and the contract expires after a certain date.

The strike price:

This is how much you are obligated to sell the underlying stock for, if the purchaser so desires.

The premium:

This is how much money the purchaser of the call is going to give you in order to entice you to enter into the contract.

Example please...

Let's pick some typical values, and work with them. Today is September 22, 2020, and CIBC is trading at $101.89.

/bin/bash: :make: command not found Let's examine the three values I talked about above:

Expiration

I choose January 2021; that's 4 months out.

Strike

I choose $105.00; it's a little more than what the stock is trading at.

Premium

I ask for $2.00 per share.

We'll get into the nitty-gritty details shortly, but let's see how this works first.

Somebody buys your contracts! You receive $2.00 per share, and nothing else really happens. You still collect the dividend that you're due in October 2020.

Eventually, the third Friday of January 2021 rolls around. (That's when contracts expire; the third Friday of the month.) There are two things that could happen.

If CIBC is trading at, let's say, $110.00 per share, then of course the purchaser of your call option is going to want to “exercise” the option. That is, they will force you to sell your CIBC shares for $105.00, even though they are worth more. If this happens, then you would have made a total of $2.00 + $1.46 + $5.00 = $8.46 on your stock. The three numbers are:

• $2.00 for the premium you received for writing the contract,
• $1.46 for the October dividend, and
• $5.00 is the difference between the strike price ($105.00) and your purchase price (we assumed $100.00 above).

Let's put a pin in this one and come back to it.

If, on the other hand, CIBC is trading at, let's say, $95.00 per share, then of course the purchaser of your call option is NOT going to want to buy your stock for the strike price of $105.00 — why would they? They can buy it on the open market for the $95.00 that it's trading at. In this case, you keep both the premium (the $2.00 you got) and the stock. You can lather, rinse, repeat over and over.

But ... but ...

And this is where most people get a little hesitant.

“You said I wouldn't lose my shares, and yet I had to sell them for $105.00 when they were clearly worth more!”, I can hear you say.

No! You can avoid selling your shares by repurchasing your options. This is the whole key to this scheme, so I'll put it in bold:

This is the whole concept of “kiting” — you're just floating the kite on new gusts of wind each time it comes close to the ground.

The “magic” here is that the options that you'll be rebuying are always going to be cheaper than options with the exact same strike price, except further out.

Why are they so cheap now?

What I mean by that is, as expiration (January 2021) approaches, the premium that the option trades at is going to get closer and closer to the actual difference between the strike price and the stock price.

At expiration, if the stock is worth $110.00, then the strike price will be $5.00 — it's the difference between the strike and the stock price ($110.00 - $105.00 = $5.00). If the stock is worth less, say $104.00, then the option has no value. It is literally worthless.

And yet — someone had paid us $2.00 for a $105.00 strike option when the stock was trading at $101.80.

Why?

Because they believed that the stock would trade higher in January than it does now, so they wanted to secure the right to buy it for $105.00, and were willing to spend $2.00 to do that. Sometimes it works out, sometimes it doesn't. We don't have a (working) crystal ball, so we can't tell.

Coming back to what happens in January, it should now be clear why a new, “fresh” option will be worth more than the one that's about to expire. In the options trade, this is called “time value”. How much is time worth?

In our example, we sold a “worthless” option for $2.00. That $2.00 was, therefore, all “time value”.

In January, even if the stock is trading at $110.00 (and thus the expiring $105.00 strike option is worth $5.00), a “fresh” $105.00 strike option for something further out, like say April 2021, will be worth more than $5.00 — purely due to time value.

Let's say it's worth $6.75. Of that $6.75, $5.00 is its “intrinsic value” (that is, the difference between the strike price and the stock price, which in this case is $110.00 - $105.00 = $5.00), and the rest, the “extra” $1.75, is its “time value”.

So what do you do? You rebuy your January $105.00 options for $5.00, and you sell April $105.00 options for $6.75.

Oh look! You just made another $1.75! And best of all, you haven't lost your shares, you still own them.

So... what's the catch?

As far as I can tell, there is no catch. Since you already have the mindset of “I want to own this stock forever,” then you're not really concerned about the stock price, just the option price.

The one rule is:

It seems simple enough, but ... Here's an example.

It's January 2020, and you just sold some nice fat juicy options on your CIBC stock that expire in April. The pandemic, sadly, does not just “blow over,” and CIBC is now trading at less than what you bought it at. The options expire worthless, which means you pocket the premium with no consequences.

So far, so good. But you have this itch. You want to write covered calls!

RESIST the temptation to write covered calls for July for $85.00 strike. Even though you can re-buy them, it will be messy. You'll pay a lot for the options, which means you'll need to get an even bigger premium for them. That means that you'll need to choose a further out expiration but keep the strike pretty much the same. Yes, theoretically, you'll eventually get out of this “loop,” but it's best not to get into it.

In this case, I'd have waited until August / September until the price recovered to the point where I could write covered calls that would not result in me potentially selling the stock for below what I paid for it.

Just sayin.

Ratcheting Up

A neat trick, which you can do sometimes, is to “ratchet up” your option strike. For example, suppose you have a $94 strike that's about to expire, but you notice that the $96 strike a few months out is giving you enough to cover both the $94 re-buy and a non-zero bonus on top of that!

Should you do it?

In general, I'd say yes, because now you've effectively adjusted your lower limit on your options by $2 higher.

It's really going to depend on how far out of the money your option is — if the stock has “gotten away on you,” then yes, you'll want to “catch up” to it by way of ratchet. If you're comfortable with the stock price and the strike price, well ... just take the bigger premium (more money in your pocket).

Practical Example

So, I bought some CM for $78. I sold covered calls for $94, figuring that that was “out there” and that there would be no way that would become “in the money” any time soon. Of course, the market recovered, and my $94 calls, which I got $3.50 for, were now worth a whopping $8.00 on the re-buy side. I was thinking, “ok, this is going to be painful. I'm 'loosing' $4.50 (the $8.00 rebuy minus the $3.50 I got) by rebuying the stock”.

However, the $96 calls for April turned out to be $8.50 — so I rebought my $94s for $8.15 (the price had crawled up a bit), and sold some April $96s for $8.50. I wasn't making a spectacular amount of money, but I had just ratchteted up my base by $2.00 and still made an extra $0.35 per share.

Sweet.

But don't take my word for it...

As an old boss of mine used to say, “The true test of a good idea is if it lasts through the hangover.”

So, let's do a back-test and see just how this works with real data. There's some analysis at the end. Keep in mind that this is just a blind algorithmic approach, with no real “insight” into the market.

Let's assume we bought CM on 2013-10-21 for the closing price of $85.35.

So, the grand total over the little over 6 years is $17.50

Like I said, this is the “blind” algorithm. There's lots of room for improvement. The algo could be enhanced such that if the rebuy price dips to some pre-defined level, like 50% of the cost, the it just goes ahead and rebuys. This could capture some dips.

Notice the ratchet in action — in 2014, we upgraded from $86 calls to $88 calls in January. We did a similar trick in 2015, and then even downgraded so as to capture a bigger premium.

There's a bit of “friction” at the $100+ level because the options then start stepping by $5 increments, which makes it a little difficult to ratchet.

So what, $17 over six years...

You might think that the numbers aren't that impressive. Remember I said this was a “get rich slow” scheme?

Let's look at another example; we'll use BNS for this one. Suppose I'm extremely lazy, and just want to do stuff once per year. So I buy BNS, and then, every January, I kite the options:

Profit so far: $11.96 (18% over 6+ years). If your shares get exercised, then you'll get your $66 back, plus the $11.96 (so $77.96) plus the dividends ($36) for a total of $47.95 or 72.6% over 6+ years. Doing the math, that's around 9.5% per year.

Yes. On a boring bank stock.

I feel awkward rebuying...

Yeah, that seems a little weird. But, if that's what you're feeling, then, hey, let's look at the numbers. Suppose you didn't rebuy?

Yes, you're now a bagholder — you own shares that you bought for $81.84 that are now worth in the mid-$50 range. This would have happened to you had you bought the shares for $81.84 regardless. If you're “clever” enough not to have bought them for that price, then you wouldn't have bought them even using this scheme, right? :-)