Another Way to Manage Risk

Option traders are familiar with the protective collar, which guards against downside risk in volatile markets, but there's another less familiar strategy, which not only guards against market risk, but also provides double-digit returns, says Michael Thomsett of ThomsettOptions.com.

The dividend collar is a strategy that is quite different than the protective collar, although as a starting point it hedges the same risks.

In the regular collar, you own 100 shares and you open a short call and a long put, both out of the money (call's strike above current price and put's strike below).

The dividend collar might do the same, or reverse the sequence, or be based on the same strike for both options. In that case, it becomes a synthetic short stock position.

In all cases, the strategy is opened with the idea of capturing the upcoming dividend while also eliminating all market risk. If you open and then close a dividend collar every month, you convert quarterly dividends into monthly dividends.

For example, you apply this strategy to three companies, each paying 4% annual dividend, and with ex-dividend cycles in different months (Jan/Apr/Jul/Oct; Feb/May/Aug/Nov; and Mar/Jun/Sep/Dec).

This results in your getting a quarterly dividend of 1% every month, meaning you end up with a 12% yield.

Market risk is eliminated due to a three-part hedge:

1) The cost of the long put is paid for by the short call.
2) The short call risk is covered by 100 shares of stock.
3) The risk of declining share value in the stock is protected by the long put.

The dividend collar is best opened a week to three weeks before ex-dividend date, and using options expiring after. As long as the net original cost is zero or a credit, the options are "free" because one covers the other. And as long as exercise produces breakeven or a profit, you cannot lose there either.

The position is closed in one of four ways:

1. Your short call goes in the money and is exercised.
2. The stock value falls below the put's strike and you exercise the put, selling shares.
3. The call goes in the money and gets exercised early, in which case you get the capital gain instead of the dividend.
4. You close the stock and option positions on your own and take profits.

This strategy has numerous variations, and a thorough study of the many kinds of risks involved will help you to develop the ideal. The best outcome, of course, is to earn double-digit returns with no market risk. This is possible only with a small window of stocks, and only if and when the parity is there and the pricing proximity is just right. But this does occur. It takes time and research but is worth it to get to that risk-free double-digit return.