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Hedging Your Way To Healthy Dividends – Part 1

We had selected 21 top dividend payers for trade ideas in Member chat last Tuesday.

Today Vitaliy Katsenelson of Active Value Investing sent me an excellent power-point he will be presenting at the CFA Society of Miami next Tuesday on Value Investing In Range-Bound Markets.  I don't want to spoil it for you but let's just say that he agrees with our premise that dividend-paying stocks are, by far, the best choice to ride out a choppy market like the one we have – one that may persist for quite some time.

Using options to hedge our dividend positions can make them even more rewarding as we protect ourselves against the occasional downturn (not to mention the little dips stocks may take as they go ex-dividend).  Another benefit of using our Buy/Write Strategy to purchase didvidend paying stocks is that, by decreasing our net entry price on the position, we are effectively raising our dividend yield – that is what they call a real win-win!  Of course, hedging a position doesn't mitigate all possible damage but it's sure better than not hedging.  The main problem with any dividend paying stock is that, if they announce they are suspending the dividend, they tend to drop like a rock so it's important to stay on top of the company and pay close attention to news that may adversely affect the dividends down the road.

Of course, this disadvantage has a flip side and 1/3 of the dividend selections we discussed on Tuesday were companies that no longer pay a dividend, have taken a big hit but may go back to paying it again down the road.

LYG was one of the seven.  From 2002 through Aug 2008, Lloyd's paid a nice $2+ annual dividend but the bank suspended their March dividend this year and may not make the August payment either.  Suspension of the dividend was the last straw for the already struggling bank and Lloyds fell from it's 2007 highs of $45 to $20 in October of 2009 all the way down to $2.22 in March.  Most of Lloyd's troubles came from good, old-fashioned lending impairments relating to the housing crisis rather than exotic trading gambles that went bad and, of course, the UK government has stepped in under the Government Asset Protection Scheme (I love that they call them "schemes" in England – that word would not go over well in the US but would be a much more accurate description) and, of course, the banks is issuing shares to raise capital just like most large banks.  

As a surviving bank and preferred mortgage lender, the company is seeing strong revenue growth this year, especially in Retail lending, where they increased market share and added 500,000 new loans.  At $5.57 a share, LYG is currently valued at $8.5Bn which is only 30% more than the $6Bn average the bank earned in 2006 and 2007.  2008 was, of course, not such a good year and the bank, after write-downs and the bank expects to have a loss for 2009 after making $819M last year so I think we can safely say they are NOT a dividend payer this year.  Why then, is it the first stock in a series about dividend-paying stocks.  Because they USUALLY pay a dividend, they have a PROPENSITY to pay a dividend and they are very likely to pay a dividend again in the future.  You can wait until the $2 annual dividend is restored and you can buy the stock then for $20 and make a nice 10% annual profit – there is nothing wrong with that.  OR, you can buy them now, while they are cheap and use option hedging to create an artificial dividend for yourself while you wait.  Sound interesting?

Assuming you were too busy to follow the link back to our Buy/Write Strategy, I'll go over the logic of our trade in detail.  We are generally bullish on LYG long-term and we do WANT to begin accumulating a position in the stock.  Let's say our goal is to own $5,500 worth of the stock or about 1,000 shares.  Rather than buy 1,000 shares at $5.57 on a stock that currently pays no dividend we can buy just 500 shares of the stock for $2,785 and we can sell 5 Jan $5 calls for $2.02, getting back $1,010.  When we sell a call we are giving someone the OPTION to purchase our stock for a certain price on a certain date.  That person is betting that the stock will finish higher than the strike they purchased.

What are we "betting" in this example?  We are not betting anything.  We already own the stock for $5.57 and we are promising to sell it for $5 on Jan 15th of 2010.  While that is 10% less than we just paid for the stock, we are not as dumb as we look because our "caller" is paying us $2.02 for the option we sold him.  He pays us that money up front and we keep that money whether he ultimately exercises his option or not.  That means our net cash outlay for buying 500 shares of the stock and selling the Jan $5 option is $3.55 per share or $1,775.  If LYG is over $5 a share (it's $5.57 now) on Jan 15th 2010, we will get "called away" at $5.  Whether it is $5.01 or $501, our caller has the right to buy our stock for $5.  That is something you have to get used to with options - you can't regret giving your caller "a good deal" later – keep in mind you used his money to buy the stock in the first place.  Your caller is your partner in this venture.

So, on this simple first stage of the transaction, we have taken on a partner who chipped in $2.02 and has no stock but does have the right to buy us out for $5 additional dollars.  We have put up $3.55 of our own money and we took possession of 500 shares of stock.  If LYG does pay a dividend, it goes to us.  What happens if the stock goes over $5 by Jan 10, 2010?  Well, our caller will give us $5, we give them the stock and our net profit is $1.45 per share or $725.  Out of the $1,775 we actually laid out, this would be 40% – quite a bit more than a dividend.  In the context to the $5,500 we were willing to spend on this trade, it's still a 13% profit but at no time did we put more than $1,775 at risk.

Don't forget, our goal was to get 1,000 shares of stock for a long-term play.  Having the cash on the side gives us two benefits.  If the stock goes down, we can scale into the position.  We are already covered to a net entry at $3.55, 36% below the current price.  Let's say LYG falls all the way back to it's lows of $2.22.  While this would be very bad news for our caller, we could simply (assuming we didn't think things would be much worse) buy 500 more shares for $2.22, which would give us an average entry on 1,000 shares of $2.89.  With an average entry of $2.89 and the stock at $2.22, we would be in 1,000 shares that are down 23% and our loss would be $670 but we would have only laid our $2,890 of our $5,500 for the 1,000 shares.  Keeping in mind that the additional commitment is voluntary, let's call that our "worst case." 

Now, here's where things get interesting.  There is another kind of option I can sell and that's called a put.  Selling a put is the opposite of selling a call.  I take money from a "putter" who pays me to give him the option of forcing me to buy his stock for a set price by a set date.   In the case of LYG, I do want to own 1,000 shares and I do have $5,500 sidelined for the commitment and my "worst case" scenario (assuming no bankruptcy or near catastrophe beyond our vision) is that I'll end up with my 1,000 shares for $2,890.  My best case scenario is a $725 profit so what should I do with my unused $2,700? 

If I sell 5 Jan 2010 $5 puts, I will get paid $1.48 in exchange for my promise to buy LYG for $5 (net $3.52 or $1,760) on Jan 15th 2010.  If the stock is above $5 at the time, there will be no logical reason for the putter to force me to take his stock for $5, if it is under $5, I will be assigned the stock at $5 and anything below $3.52 at the time will be a loss for me.  Keep in mind that, depending on your margin arrangements with your broker, you will have up to $2,500 held against your account for the potential purchase of the stock.  Effectively, by coupling this arrangement with the stock I have purchased and the calls I have already sold I have created a situation in which I am laying out $2,785 for the stock and obligating myself to buy 500 more shares for $2,500.  I have sold 500 $2.02 $5 calls for $1,010 and 500 $1.48 $5 puts for $740 so my maximum net payment for 1,000 shares would be $3,535, a full $2,035 less than if I bought them today (36%).

So Lloyds could DROP 30% between now and January 15th, 2010 to $3.90 and you could be forced to buy 1,000 shares for a net average of $3.54 and you STILL make 10% in 7 months.  Is this getting interesting yet?  Don't forget that when and if LYG is assigned to you below $5, as long as they are above $2, we will be able to sell the Jan 2011 $2.50 calls and give ourselves ANOTHER massive discount on our 1,000 shares. 

In summation, we are only laying out $1,035 in cash and we are taking possession of 500 shares of UYG, even though the stock is currently $5.57 per share.  If we get called away, we will collect $2,500 for our 500 shares and our putter will expire worthless, netting us a $1,465 profit or 141% on cash.  Even if you had to commit the entire $2,500 to margin to honor your commitment against the puts you sold, you are tying up just $3,535 to make that same $1,465 – a profit of 41% in 7 months.  By the way, always make sure the cash held aside for margin is working for you.  If your broker doesn't have a program that gives you interest on the cash in your account – get another broker!

I know that's a lot to digest but it's a fantastic strategy once you get used to it.  I can't resist mentioning that, since you do have $4,535 of cash that you were willing to commit to this position on the side lines you can also manage your position to make sure that the stock doesn't run away from you to the upside.  If you set a buy stop at $6, committing to buy 500 more shares for $6 ($3,000) if the stock goes up and stopping back out at $6 if the stock breaks back down, you will only be increasing your downside net by the transaction costs of buying and selling at the $6 line (for most discount brokers, just $10 per entry and exit) but you are insuring that, even if called away at $5 when the stock is at $6+, you would still have 500 shares remaining with an average entry price of $4.04 (27.5% less than current) and the stock over $6 with no callers to limit your upside, ready to sell the next round of options if you wish.

As we like to say at PSW, there is always an option and hedging your dividend plays is a great way to scale into a long-term position, mitigating the risks and enhancing the profits.  Selling options is a very valuable investing tool and well worth your time to learn these strategies, which quickly become second nature if you practice – take it from a guy who has already taught this system to over 1,000 members over the past few years:  You can learn this and you can profit from this and it is worth doing!

 


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  1. Vitaly gave this presentation abpout 18 months ago in Madison at the CFA meeting.  Lot’s happened since.  He is an engaging and bright speaker.  Selling puts also makes sense if you want to end up with the stock


  2. Interesting negatrive Article on Sears and Eddie Lampert
    Link: http://online.barrons.com/article/SB124294027534244765.html


  3. I like this one and it will be on my list for next week.
    Been meaning to ask about an updated gold play. What looks good now?


  4. pstas
    I think gold will be taking a run at $1000/oz very soon, and if it breaks through then look for $1300/oz.
    My play for next week is AU (Anglogold Ashanti Ltd) currently priced at $37.62. Selling Jan. 35 puts/calls for $13.20 – 35% discount. For a closer expiration – look at July calls for $4.80


  5. [...] In Part 1 of this post, we talked about the potential long-term value of taking a chance on companies that used to pay dividends but don’t at the moment.  In addition to the 7 selections we had last Tuesday, I would urge members to keep on the lookout for additional prospects we can discuss as the long-term benefits of catching these stocks at the lows can be amazing!  This was the same logic that led me to pound the table back in March on C, BAC, WFC, JPM and even the hated GS – stocks that have tripled or better in just 3 months. [...]


  6. [...] Part 1, we discussed the idea of going after former dividend payers who may bounce back while creating an [...]