It costs about five times as much to insure a Ferrari than a regular car. That's partly because with top speeds above 200 mph, the probability of an accident is much higher in a Ferrari.
The options market is built on that same principle of risk versus reward -- except instead of fast cars, it's all about the VIX.
Also known as the "fear index," the VIX measures investors' expectations for volatility in the S&P 500 Index in the next 30 days. When the VIX is high, the market is expecting lots of volatility -- and for options traders, there is nothing more important than the VIX. It is the single most important factor affecting options pricing.
With the Federal Reserve crushing expectations of weakness in the S&P 500, the VIX has been near record lows:
That low reading on the VIX is both good and bad for put sellers.
It's good because it lowers the probability of being put shares. But it's bad because it reduces the value of the premium I collect when selling a put. And with the VIX falling for the past few years, it has become less profitable to sell puts.
But in spite of that bearish trend, there are a couple of techniques I am going to use to increase the value of the premiums I collect.
The first is expiration. My target expiration range when selling puts is 45 to 60 days. With options, time is money. Long-dated expirations carry higher premiums because they create a larger window for an unexpected event. By targeting the long end of that range, I'll be able to increase the value of the premium I collect without taking on too much time risk.
The second technique I am going to use is selling a put at a strike price that is relatively close to the money. My target range for selling puts is usually 10% to 15% out of the money. That range is fairly conservative by most options trading standards, but by targeting the low end of that range or even dipping below it slightly, I can give my premium another boost.
[More from StreetAuthority.com: 14% Yields From A Country Where Dividends Are Required By Law]
Keep in mind, extending expiration and increasing "moneyness" (basically, an option's current intrinsic value) both increase the risk of being put shares. Higher premiums always correlate to accepting more risk. To offset some of that risk, I want an underlying company that looks undervalued, carries a solid dividend and has an impressive dividend growth rate.
From the S&P 500, I screened for companies with dividend yields of at least 2.7%, a five-year dividend growth rate of 18% or more, and a forward price-to-earnings (P/E) ratio of 14 or less. Thirteen stocks emerged:
From that list, I went with one of the most powerful and recognized brands in the world. This company is currently executing huge buybacks and transforming itself into a dividend payer. And its shares are undervalued.
Microsoft (Nasdaq: MSFT) isn't a name most investors think of as a dividend stock. But the reality is that Microsoft is long past its days of gangbusters growth and is now settling in comfortably as a powerful dividend payer. Since launching its dividend program in the spring of 2003, the company has become one of the most aggressive dividend payers in the S&P 500.
Microsoft pays a 2.7% dividend yield, a 50% premium to the S&P 500's 1.8%. That dividend has been hiked 22% in the past 12 months, and Microsoft's five-year and three-year dividend growth rates rank among the highest in the S&P 500. But in spite of that solid yield and impressive growth, the company's payout ratio has ranged between 25% and 39% over the past five years. That means Microsoft is on course to deliver more value to shareholders with future dividend increases.
Beyond Microsoft's growing dividend, the company also continues to deliver steady growth in sales and earnings. The company had a record $78 billion in sales in 2013. That produced earnings of $2.60, just $0.09 short of its record in 2011.
Those sales and steady earnings growth have turned Microsoft into a financial powerhouse.
In the past five years, its stockpile of cash has tripled, climbing to an amazing $78 billion. But Microsoft isn't letting that pile of cash sit in a vault and collect dust. It's putting that cash to good use with massive share buybacks. After completing a $40 billion buyback program in September, Microsoft turned around and announced another $40 billion program that same month. With a market cap of $303 billion, that $80 billion invested in buybacks equates to 26% of the company's current value.
[More from StreetAuthority.com: The Best Stock For The Global Food Crisis]
But don't expect Microsoft to have to dig into its prodigious cash pile to pay its dividend. With free cash flow hitting $24 billion in 2013, the company has plenty of earnings power to fund its dividend while also strengthening its balance sheet. That leads me to expect Microsoft will get in the habit of issuing special dividends to chip away at its growing cash position.
Microsoft does have its critics, who point to shrinking PC sales and its late entrance into mobile. But that's a short-sighted view of the company. Microsoft is making progress on the mobile front with its Windows 8 operating systems and Surface tablets. And its leading position in other markets gives it a great platform to expand its presence in the high-growth mobile market.
That short-term pessimism over Microsoft's presence in mobile has shares trading at a relative discount. In spite of a 33% gain in 2013, Microsoft's forward P/E ratio of 14 is a discount to its peer average of 18 and the S&P 500's 15.5.
After last year's gain, MSFT is trading at a five-year high above $36. So instead of buying shares outright at that high, I am going to sell puts.
On Friday, Microsoft closed at $36.38. This week, I recommend selling the MSFT MAR 32 puts for $0.32.
Selling these puts will generate instant income of $32 that will be deposited directly into a brokerage account. It also obligates us to buy Microsoft for $32 if shares fall below that level on March 22, when the options we sold expire.
As I said, the two key features of this trade are pushing the options expiration back to the long end of my target range between 45 and 60 days.
Shifting our expiration month back to March from February increases our premium payment at the $32 strike to $0.32 from $0.20, a 60% increase.
[More from StreetAuthority.com: Forget American Stocks... And Get A 6% Yield From This Safe Country]
In terms of moneyness, selling a MAR put with a strike at $32 pays a $0.32 premium. That is just 11% away from being in the money. I could lower my strike by just a dollar, to $31, and increase the probability of the options expiring worthless -- but the premium would fall to just $0.23, a 28% decrease. And since I'm bullish on Microsoft in both the short and long run, I'm willing to increase moneyness to support a higher premium.
All things considered, this is a high-probability trade, with an 88% chance of the option expiring worthless.
Action to Take -- > Being put 100 shares of Microsoft at a strike price of $32 would require a $3,200 investment. But to initiate this trade, I won't need the full amount. Most brokerage firms require a 20% deposit to control the position. That puts my margin deposit for the Microsoft trade at $640.
Here's how the trade looks if the options expire worthless. A potential 5% return in just 34 days compounds out to a potential 30% gain in 12 months, without buying a single share of Microsoft.
Here's how the trade looks if we are put shares of MSFT: