Funtap
We all love safe, steady returns.
I will show you how to use stock options to both REDUCE the risk of owning a real estate investment trust (REIT) as well as to LEVERAGE your returns while you own the stock. Sound too good to be true? Not if you use some very basic option strategies. I’ll be happy to explain to you…
If you want to set up a good options spread on a high-dividend stock, you want to wait for the stock to come to a good options strike and, fortunately for us, two of our favorite REITs, Chimera Investment Corporation (CIM) and Annaly Capital Management, Inc. (NLY) are at $5.02 and $19.95 respectively – both good strikes to play.
The problem REITs have is that they are required by law to distribute at least 90% of their taxable income to their shareholders. This means that they have little room to reinvest their earnings and grow their assets. As a result, the stock price of REITs tends to stay flat over time, reflecting the stable income they generate from rents and mortgages. However, this does not mean we can’t use options to turn them into a fantastic investment. By selling covered calls and using puts with our REITs, we can create a strategy that reduces our downside risk AND enhances our returns.
I will show you how it works but first a bit about CIM and NLY:
CIM and NLY are both real estate investment trusts that invest in mortgage-backed securities and other types of real estate debt. They make money by collecting interest income from their investments. The two companies have many common directors and officers. For example, Kevin G. Keyes is the Chairman, CEO, and President of NLY, and also a director of CIM. David Finkelstein is the CIO of NLY, and also a director of CIM. Mohit Marria is the CIO of CIM, and also a director of NLY. The two sister companies do have some differences in their investing style:
CIM focuses on residential mortgages, both agency and non-agency, as well as commercial mortgages and other types of loans. CIM uses leverage and hedging to enhance its returns and manage its risks. CIM has a higher dividend (13.94%) yield than NLY (13.03%), but also a slightly higher risk profile.
NLY is the largest mortgage REIT in the US, with a diversified portfolio of residential and commercial mortgages, both agency and non-agency, as well as other types of real estate debt. NLY also uses leverage and hedging but with a more conservative approach than CIM. NLY has a lower dividend yield than CIM, but also a lower risk profile.
Higher rates have chased many investors out of the REIT sector but here are some reasons why CIM and NLY could be standout REITs for long-term investing:
- They have a proven track record of delivering consistent and attractive dividends to their shareholders, even during periods of market volatility and uncertainty.
- They have experienced and capable management teams that can adapt to changing market conditions and seize new opportunities.
- They have diversified and high-quality portfolios of mortgage assets that generate stable and predictable cash flows.
- They have access to low-cost and flexible financing sources that enable them to leverage their returns and manage their risks.
- They have strong balance sheets and liquidity positions that allow them to withstand market shocks and maintain their dividend payouts.
I would encourage you to do your own research, of course, this article is mainly focused on HOW to manage our risk and leverage our returns once we have identified good candidates – and these are the candidates that will serve as an example. Let’s allocate $10,000 to each stock and see what we can come up with.
CIM:
- Rather than spending all $10,000, let’s spend $5,020 on 1,000 shares of CIM at $5.02
- We will promise to buy another 5,000 shares by selling 10 Jan, 2025 puts for $1 ($1,000).
- We will promise to sell our stock for $5 by selling 10 Jan, 2025 calls for 0.75 ($750)
That’s net ($5,020-$1,000-$750=) $3,270 out of pocket and, assuming this is a non-margin retirement account, we also have a $5,000 obligation to buy 1,000 more shares if CIM is assigned to us at $5. That’s all a put option is – a promise to buy a stock at a certain price – you are either a buyer or seller and, in this case, we’re selling them and taking the obligation.
The call that we sold gives someone else the right to “Call” us away and sell them our stock for a fixed price. While this somewhat caps our gains, the upfront cash lowers our layout when we initiate the trade.
So, we’ve laid out $3,270 and if the stock is flat – we keep it and sell more puts and calls in a year. If we can lower our basis by $1,750 per year, we’re just two more years away from a free stock! We call this method “Wash, rinse and repeat.” Meanwhile, CIM paid 0.18 in dividends on Sept 28th so we have $180 coming to us on Dec 28th and then $700 over the course of next year if the dividends continue as they are.
If the stock goes up, we will get called away at $5 with a $1,730 profit plus some (if called away early) or all of our $880 in anticipated dividends and that’s $2,610 back on our $3,270 cash outlay (79.8%) but, if we are in a no-margin account – we’re tying up $8,270 so the return is “only” 31.5% – that’s our return if the stock is flat or up from here ($5.02) in 13 months!
If the stock goes down, we will be forced to buy 5,000 more shares at $5 but we keep the $1,750 from the short puts and calls and, if we collect our dividends – another $880 is $2,630 against the ($3,270 + $5,000 =) $8,270 is net $5,640 for what are now 2,000 shares or $2.82 per share. So our worst-case scenario is owning 2,000 shares at a 43.8% discount to the current price.
Aren’t options fun?!?
That’s why we can sell puts with very little fear of being assigned. If we wanted to buy 1,000 shares of CIM at $5.02, why would we not want to buy 2,000 shares at $2.82? People have an irrational fear of option assignment because they don’t really understand the mechanisms properly.
NLY:
- Just as we did with CIM, rather than spending all $10,000 on NLY, we can instead buy 300 shares for $5,985
- We will promise to buy another 300 shares by selling the 2026 $20 puts for $4.50 ($1,350)
- We will promise to sell our 300 shares for $17 by selling the 2026 $17 calls for $3.15 ($945)
That’s net ($5,985 – $1,350 – $945 =) $3,690 out of pocket and, assuming no margin ability, we have an obligation to buy 300 more shares for $20 ($6,000) if assigned to us.
If the stock stays over $20, we collect an 0.65 dividend ($195) on Dec 28th and 8 more in the next 2 years is $780 so $1,755 total against our net $3,690 entry is 47.5% back on our cash outlay and we would be called away at $17 ($5,100) with a ($1,755 + $5,100 – $3,690 =) $3,165 net profit. That would be a return of 32.6% over two years against the $3,690 cash outlay and the $6,000 obligation from the short puts.
If the stock is below $20, we are assigned 300 more shares for $6,000 and we laid out $3,690 originally and collected $1,755 in dividends so net $7,935 for 600 shares is $13.225 per share and that’s our break-even (assuming the dividends continue) and that’s a 33.7% discount to the current price.
Options are fun!!!
If we diversify $20,000 over our twin REITs and all goes well (it rarely does), then we’ll pick up 16.3% on NLY while CIM contributes 31.5% for an average of 23.9% annual return with a worst-case on each stock being assigned more and averaging a 38.7% discount to the current prices.
Options are not just financial instruments; they’re tools of empowerment for the savvy investor. By understanding and employing them wisely, we can transform seemingly stagnant investments like REITs into dynamic, profitable ventures.
In the current economic landscape, where interest rates and real estate trends are as unpredictable as a game of poker, these strategies offer a way to play your hand with confidence.
Risk Management and Exit Strategies:
No strategy is without risk, but the beauty of options is in their flexibility. If the market moves against us, we have exit strategies and adjustments at our disposal, ensuring we’re not left holding the bag.
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