They can be a source of cash or a source of information. By Al Root

Income investors usually want to keep it simple, and stock options are anything but. They can still be a useful tool, however, especially when pondering the safety of a dividend.

That's not the first thing that people typically think of when they contemplate stock options. Though they're often viewed as synonymous with speculation, they can also hedge positions, provide portfolio income, and gauge the potential size of stock moves around significant events such as earnings.

Options, as their name suggests, give the holder the "option" to buy or sell a stock at a fixed price in the future. Call options give the right to buy a stock, while put options grant the right to sell. How does that work? Let's say investors think Nvidia stock will go up. They could buy shares for a recent $132, and wait. If the stock trades to $240, they would make about 82%.

But for $10, investors who believe that Nvidia stock is heading higher can purchase a call option on the stock that gives them the right to buy the shares for $200 each in about one year. If the stock trades up to $240 in a year, they would then execute the option, take ownership of the stock for $200, and then sell it for $240, giving them a gain of $30 -- they paid $10 for the option -- or 300% on their initial investment. Of course, an option can be an all-or-nothing bet. If Nvidia stock closes below $200 in a year, the $10 disappears.

Investors don't need to buy and sell options for them to be useful. Options can also tell investors a lot about the safety of the dividends for the stocks they own, says Garrett DeSimone, head quant at OptionMetrics, a 27-year-old research firm. That's a valuable tool these days, considering the volatility induced by trade wars, geopolitics, and recession fears.

The math to determine dividend direction can get complicated. Options prices reflect a lot of factors simultaneously, including a stock's expected volatility, the time to expiration, the level of interest rates, and, yes, dividend payments. Traders have to account for all of these when figuring out what to pay for an option, and if all other factors are controlled for, it's possible to see what traders are predicting for the dividend.

They're not always right. After Covid-19 crushed markets in early 2020, options prices for Philip Morris International reflected a dividend cut. The cut never arrived. Instead, the company raised its dividend about 3% that year. More recently, markets took a dip around President Donald Trump's April 2 "Liberation Day," as investors worried that high tariff rates and an escalating trade war would create a Covid-like market crisis. The Cboe Volatility index -- better known as the VIX -- spiked from less than 20 shortly before the announcement to more than 50 in early April. Despite the volatility, options on Philip Morris, which yields 3.1%, never reflected a dividend cut after the tariff announcements, says DeSimone.

Philip Morris is known for the safety of its dividend, but what about some others with high yields that appear increasingly uncertain? DeSimone looked at chemical makers Dow and LyondellBasell Industries, which yield 9.3% and 9%, respectively, and food company Kraft Heinz, which has a 5.7% payout, and found that the options market isn't implying a dividend cut in their futures. There's no guarantee that the companies won't cut their dividends. Dow and Lyondell have been suffering from depressed earnings and cash flow resulting from falling chemical prices amid weak global demand . Kraft, for its part, hasn't grown earnings for a decade and recently announced a strategic review to boost lagging performance.

Those situations have made investors nervous. The options analysis, however, suggests that there's reason for optimism. For income investors, it's a place to start.

Write to Al Root at allen.root@dowjones.com

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May 23, 2025 21:30 ET (01:30 GMT)

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