Juice Up DRIP Returns With Options via 'PRIP'

NEW YORK (TheStreet) -- Although they don't sound too attractive, DRIPs -- dividend reinvestment plans -- offer the opportunity to grow assets by gradually converting an income stream into more shares without fees. It's also a solution for the inveterate buy-and-hold investor because it allows for the magic of compounding.

DRIPs are old-fashioned: Investors buy equity shares directly from the company and enroll in its DRIP program to reinvest dividends into new shares. Investors can also set up regular stock purchases. Often investors buy fractional shares and odd-lot shares through DRIPs. Through the plan, you might also be buying at a time that you wouldn't ordinarily want to buy shares in that particular company.

For those advocating a dollar cost averaging approach, note that to truly cost average one would need a large portfolio of dividend-paying stocks with payment dates broadly distributed to achieve a sufficient sampling of the market's ups and downs. Otherwise, since dividend dates are clustered on a quarterly basis, one is at the mercy of the dividend schedule.

Using the 2013 S&P 500 average for dividend yields, DRIP investors could earn a quarterly income stream of approximately 0.5% per eligible position. For example, anyone reinvesting quarterly dividends on 1,000 shares of Microsoft (MSFT), which offers a dividend yield nearly 51.7% higher than the S&P 500 average, would be able to add approximately 7.6 shares.

While there is certainly a body of evidence that suggests the out-performance of dividend-paying stocks, I have never fully understood the allure of dividend-centric investing. You get the opportunity to pay taxes in exchange for the privilege of being able to reduce your stock's cost basis, to summarize the transaction.

But for many the dividend represents a tangible expression of ownership and sharing of good fortune. What better way to reciprocate that good fortune than by re-investing the dividend for even more shares?

However, small quarterly distributions -- and being held hostage by dividend payment timing -- conspire to make the DRIP strategy inefficient for those interested in compounded growth, or for those who don't have the patience to wait many years.

Is there a way to make DRIPs more appealing?  Yes -- with option sales.

Remember that Albert Einstein purportedly referred to compound interest as the greatest of inventions. He would have added some additional superlatives had he known about the use of premiums derived from option sales to fuel share purchases and asset growth.

DRIPs rely on the muted power of dividends. I suggest an enhanced DRIP strategy: selling options on core holdings (like Microsoft) can return a nice weekly, monthly or yearly premium. Anyone can design a personalized premium reinvestment plan -- what I call a PRIP.

In general, I prefer the use of weekly options, but that requires more maintenance and attention than many individual investors are willing to dedicate.

However, it can pay off. For example, anyone purchasing 1,000 shares of Microsoft at Friday's close of $36.69 could have sold 10 weekly contracts at a $37 strike price for $490. Compare that to the $280 quarterly dividend. Of course, the shares may be assigned or the contract may expire. But that allows the holder to look for additional opportunities to sell new contracts, perhaps even holding shares at the time of the ex-dividend date and doubly reaping rewards.

While the option premium income can't be reinvested in additional shares at no cost, it can serve as a building block for additional share purchases in any position desired, not just the income producing stock. Furthermore, a purchase of new or additional shares can be done at the most propitious time, rather than on a predetermined date. Selling option contracts on portfolio holdings can generate enough income to purchase entirely new positions, and in sufficient quantity to have their own income-producing option contracts sold.

If you're a buy-and-hold kind of an investor and don't really like the idea of being subject to assignment on a short-term basis, then look at the longer-term option contracts. The beauty of the derivatives market is that there is no shortage of time frames or of strike levels available. Investors can customize risk and reward, as well as the time frame in which to invite exposure.

An option contract expiring Jan. 18, 2014, also with a $37 strike price, affords a premium of $1,120, in addition to possible gains on shares if assigned. To put that into perspective, the premium yield of 3.0% for a 5-week period would be sufficient to repurchase 30.5 shares of Microsoft. As with the weekly contract, if the shares are not yet assigned, they then could be, creating the opportunity to generate even more income.

For those who can't be bothered by monthly contracts or who may want to emphasize share gains over income, consider the sale of a longer-term contract, or LEAP.  With a LEAP (or long-term equity anticipation security) expiring in January 2015, your $40 strike option contract sales generate an immediate receipt of $2,150 in option premiums.

Also, unless Microsoft rallies well past $40 prior to expiration, as the owner of the shares you will also receive deferred income in the form of $1,120 in dividends. In this instance, if shares are assigned, the ROI is 19.8%. If not assigned, the total income yield would be 8.9%, regardless of disposition of shares.

I know that "PRIP" doesn't really sound appealing when said aloud, but investors can get over the unfortunate acronym once the fun starts and the Einstein inside begins to show.


At the time of publication, the author held no positions in the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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