Interesting way to select dividend stocks

I just ran across an article that Kapitall has on SeekingAlpha that posits an interesting and, I believe, useful way to screen for dividend paying stocks.   The basic idea is to look for high-yield stocks that also have a high level of open interest in call options vs. put options.

What does this indicator mean?  In theory, people buy call options when they believe that a stock is likely to go up and they buy put options when they believe a stock is likely to decline.  The premise in the Kapitall article is to look for stocks with high yields that also appear likely to go up according to the open interest on puts vs. calls.  So, these stocks seem like they are likely to be winners on the perspective of yield and price appreciation.

From my perspective, the story looks a little more nuanced.  First, people who invest in dividend stocks are more likely to be income-oriented investors.  As such, they are quite likely to buy the stock and then to sell covered calls against their positions to generate more income.  It seems quite possible that the high level of open interest on the calls may have more to do with having a large population of income-seeking owners of the stock than with a speculative view of upside potential.  In other words, owners of the stock may be willing to sell off the upside and price the calls accordingly to get these calls sold.

In addition, the open interest measure ignores the relative cost of the options.  It may be that put options on some of these firms are really expensive and that’s why the open interest is low.  There is, however, evidence that option open interest in puts vs. calls has been shown to be a useful predictor of future performance.  Another predictor of upside potential is to look at the relative prices of options, rather than the volume.  In a paper called  Deviations from Put-Call Parity and Stock Return Predictability, the authors find that the relative costliness of calls vs. puts is a meaningful predictor of future performance.

The issue of whether these studies are entirely applicable for high dividend stocks is worth considering.  In a 2009 study titled  Implied and Realized Volatility in the Cross-Section of Equity Options, the authors find that options on low-Beta stocks and value stocks (low market to book) tend to be consistently over-valued.  This important study suggests that the markets for options on value stocks seem to be quite different from the market for options on growth stocks.

The most compelling case for the use of the put/call ratio of open interest on options is that it seems likely that stocks with a low put/call open interest are not in deep distress.  It is often the case that dividend yields look high simply because the price of a stock has collapsed and the company has not yet cut the dividend.  I would be very surprised to see such a stock with a low put/call open interest ratio.

(Editor’s note:  If you’d like to learn some more about Kapitall,  co-founder David Neubert shared his  ideas on building a portfolio with Portfolioist in this recent interview.)

This entry was posted in Income Investing and tagged , , , on by .

About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for an energy trading firm. In 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002. Geoff has published commentary and analysis in a range of publications. Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com (http://www.foliofn.com)). Neither Quantext nor Geoff Considine is an investment advisor.

2 thoughts on “Interesting way to select dividend stocks

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