On Wednesday, cigarette maker Philip Morris International (NYSE: PM) announced that it would increase its dividend by 10.6% to $3.76 per share from $3.40. Not surprisingly, the stock moved higher, gaining 2.8% on the day.
When a stock shoots higher on good news, long-term investors often want to wait for a pullback before buying. However, there are times when they never get that chance as the uptrend simply continues. Rather than waiting for a pullback, there is a simple income strategy that reduces the risk of buying while a stock is moving up.
[ad#Google Adsense 336×280-IA]The impact of the dividend increase on Philip Morris’ stock price may be fairly simple to assess.
If the dividend increases by 10.6%, then the stock could gain 10.6% and still offer the same yield it did before the dividend increase.
PM will not gain 10.6% immediately, but it could drift slowly toward that price target.
Investors waiting for a better price may miss out on this opportunity if the pullback never occurs.
Rather than waiting, investors can buy PM and immediately sell a covered call against their position to reduce their risk.
A call option gives the buyer the right, but not the obligation, to buy 100 shares of stock at a predefined price (the strike price) at any time before the option expires.
Call sellers earn instant income by taking on the obligation to sell 100 shares of the stock if it moves above the strike price before expiration. So the trade-off for the income received upfront is that the covered call seller will accept a predefined profit. However, if the stock does not move above the strike price before expiration, they will be able to sell additional calls and generate additional income.
The night prior to announcing the dividend increase, PM closed at $84.23. If the increased dividend makes the stock 10.6% more valuable, it would be worth about $93.16.
Seeing a gain of 2.8% in the stock on Wednesday, some traders might choose to wait for a pullback to buy. Rather than wait, though, a covered call strategy generates immediate income and lowers your cost basis.
For this strategy, you would purchase 100 shares of PM, currently at $86.56, costing you $8,656. You could then sell a call expiring in December with an exercise price of $92.50, just below the target price. That call is currently trading at $0.58. Each call covers 100 shares of the stock, so you would generate immediate income of $58.
The income from the call sale lowers your net cost per share to $85.98, or by 0.7%. This does not fully offset the appreciation related to the dividend news, but it is equivalent to buying on a small pullback.
If PM is trading above $92.50 when the option expires in December, you would be required to sell your shares at that price. With a cost basis of $85.98, you would realize a 7.6% gain in just over three months. When you factor in the $0.94 quarterly dividend paid on Oct. 11, to shareholders of record on Sept. 26, you would have a gain of 8.7%.
If PM is trading below $92.50 when the option expires in December, you could sell another call to further increase your income beyond the dividend payments.
— Amber Hestla