A High-Return Low-Risk Strategy

04/23/2013 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

This strategy is a three-part hedge that sets up double-digit annual returns from dividend yield, while eliminating market risk in the underlying stock, says Michael Thomsett of ThomsettOptions.com.

I have gotten a few questions recently about the dividend collar. One was, "Do you publish a list of stocks for dividend collars on your website?"

Because mine is an educational site and not an advisory service, I never make recommendations. The dividend collars I enter in the virtual portfolio are intended as examples of how the strategy works. Any time the price moves, even slightly, the relationship between the options and stock changes as well. Once you understand the components of this trade, you can find dividend collars with a little research. I have not had trouble finding them at all; last month, I opened five of them. But these are not fixed strategies, since the timing of entry is key.

Another question involves a perceived loss when a put is exercised: "If I exercise the long put and sell stock at the strike, I have to take a loss on the put." This is not true. To understand the dividend collar, you need to get away from the traditional view of each option as separate trades. Because you open a short call and a long put, think of it as a single position. The long put is paid for by the short call, so your basis in the collective option positions is zero (or perhaps a small credit).

This means that when the last trading day arrives (as it did this past Friday), one of two outcomes is likely to occur:

  1. The call is in-the-money and your shares are called away. The put expires worthless. In this outcome, you profit from the dividend, any credit in the options, and any capital gain in the stock.

  2. The put is in-the-money and you exercise your put, disposing of shares at the strike. The short call expires worthless. Here, too, your net outcome is profits from the dividend, any capital gain, and any credit in the options.

In both cases, you have a profitable outcome, based largely on earning the dividend, and without any market risk.

So where can this go wrong?

NEXT PAGE: Ways of Doing a Dividend Collar

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This week, two of the dividend collars with April puts were "calendar" dividend collars, meaning the short call expires in May. I think this is one of many ways to do a dividend collar, especially if you don't mind earning the dividend and then converting to a covered call. Here are the two outcomes:

  1. General Dynamics (GD) consisted of 100 shares @ 70.31, an APR 70 put and a MAY 70 call. On Friday, the stock was worth $66.56 so I exercised the long put and sold 100 shares @ $70, taking a $31 loss. I also closed the MAY 70 call and took a $155 profit. This was not a bad outcome, considering that I also earned the dividend of $56 on April 8 as part of this trade.

  2. Colgate-Palmolive (CL) consisted of 100 shares bought @ 116.75, a long APR 115 put and a short MAY 115 call. The problem with this position is that the strikes are well below the basis in stock. So on Friday, I let the put expire worthless and I left the MAY call in place. This is now a covered call position; but the problem remains that the call is in-the-money and the strike is below the purchase price of stock. The basis in the call has to be considered as zero since its premium was used to buy the put. So on this one I have a problem I'll have to contend with by May's expiration.

The calendar version of the dividend collar leaves a lot to be desired. It's easier to find because the later-expiring call has more time value. But you cannot rely on the situation like General Dynamics (GD), in which I was able to offset a profitable call for favorable change in the stock (via put exercise). It's much better to seek out the rarer but more realistic same-month option expirations.

Remember, though, the virtual portfolio's trades are for educational purposes, so we can learn a lot by entering strategies that seem good at first but don't turn out as well as we thought.

By Michael Thomsett of ThomsettOptions.com

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