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Monday, March 4, 2024

Hedging Your Way To Healthy Dividends – Part 3

We're going to go out with a bang here and give you a 3-for-1 in this final post on the issue.

In Part 1, we discussed the idea of going after former dividend payers who may bounce back while creating an artifical dividend through option hedging.  In Part 2 we looked at using the buy/write strategy to give ourselves a nice discount on the stock, giving us a 30% hedge on the stock on top of the dividends.  Today we will look at a couple of ways to play the safer bets and how to simply and effectively boost your dividend yield while also protecting your investment.

In Tuesday's post we had 21 dividend payers divided into 3 categories.  We'll look at what we consider a "pretty safe" dividend payer, PGH, who pay a MONTHLY dividend of about 8 cents on a $8.11 stock (12%) as well as our long-time favorite, KMP who pay about $1 per quarter and our Blue-Chip selection will be CAT, who have a 4.9% dividend and are trading at a nice, cheap $34.31.

As we have 3 trades here I'm not going to go too heavily into the merits of each one.  Suffice to say we like them at these prices and we like the option hedges we can put to work on the postions… 

PGH is a stock we went crazy for back in March, when they were under $5 but that was when they were in the category of stocks where people felt the dividend was in jeopardy.  It didn't take much for them to fly back to $8.11 but, through the magic of hedging, we can knock that price back to an entry price of $5.29 by selling the Jan $7.50 puts and calls.  As always, our major risk is that the stock falls below $7.50 and another round of shares are put to us at that price on Jan 15th.  That would create an average entry of $6.40, which is 21% below the current price.  Should we get called away as $7.50, that would be a $2.21 gain on cash so 42% PLUS 7 months worth of dividends, perhaps another .56.

Sticking with our $5,000 per position maximum risk, we can make the play the following way:

  • Buying 400 Shares at $8.11 ($3,244)
  • Selling 4 Jan $7.50 calls for $1.50 and 4 Jan $7.50 puts for $1.32, netting $2.82 ($1,128)
  • If the stock is put to us on Jan 15th we will own 800 shares at an average of $6.40 ($5,120)

As long as PGH keeps paying an 8-cent monthly dividend, our annual return on $5,120 is a whopping $768 or 15%.  As a kicker, PGH paid a .20+ monthly premium from Aug 2005 through Sept 2008 – THAT'S why we like this play.  Look at it as a way to offset higher energy costs – if you invest $5,120 in PGH, if gas goes back to $4 per gallon, there's a very good chance you'll be getting a $160 monthly check to offset the costs!

KMP is also in the energy business so be aware that these two are NOT diversified as a set but there's nothing wrong with going halves on each for your energy segment if you are limited in investment size.  Another long-time favorite of ours, KMP is going to be less exciting than our smaller plays but also closer to a Blue-Chip investment.  Since the stock is closer to our budget and does pay a $1 dividend in July and October, this is a good time to learn one of our "stupid options tricks" that lowers your risk significantly on a stock.

  • Buying just 100 shares of KMP for $47.55 ($4,755)
  • BUY the Jan $57.50 put for $12.35 ($1,235)
  • Sell the Jan $37.50 puts for .95 ($95).
  • Sell the Jan 2011 $55 calls for $1.20 ($120)

This may be tough to get your head around but you are paying a net of $57.75 for your shares and the put options you purchased guarantee your right to sell those shares (should you wish) on Jan 15th for $57.50.  Your risk on the trade is .25 as long as it doesn't fall below $37.50 and trigger the other put.  That being the case, a stop should be placed on that put at $1.50 so you are now risking losing .80 between now and Jan 15th.  If you do NOT stop out the put, you would still be able to exercise your put to sell your existing shares for $57.50 and you would have another 100 shares put to you at $37.50 and you would still have the Jan 2011 caller at $55 but they would be far out of the money of course.  That would leave you in KMP at net $3,775 – 20.6% lower than the current price and that would make your $2 dividend collected by Jan 15th 5.3% over 6 months.

Our final selection is CAT, another much loved pick that's no longer the bargain it was in March.  We like CAT on the global infrastructure stimulus as well as the weak dollar.  For CAT we looking to collect a .42 quarterly dividend on a $34.31 stock (5%) and here the best play is a very simple one:

  • Buy 200 shares of CAT for $34.31 ($6,862)
  • Sell Jan 2011 22.50 calls for $14.20 ($2,840)

That puts us in 200 shares at net $20.11 ($4,022) with no downside obligation, protected against a 41% drop in the stock.  Our expectations are to collect 7 dividend payments (expiration is Jan 21st, 2011 and dividends are usually paid in the first half of the month) of .42 or $2.94, which is 14.6% over 20 months – not bad with a 41% margin of error!  Of course we could get fancy and sell some puts too and, if you have a margin account, that's a no-brainer but this is the sort of return you can be happy with straight out and, even if you do get called away at $22.50 in 2011 – that's still yet another $2.39 in profit, an 11.9% kicker to close out the trade.

Yes, dividend paying stocks provide the best return in a sideways or even a down market.  Learning how to use options to hedge your dividend paying stocks can make them even more rewarding, allowing you to own more shares, collect greater net dividends as well as providing you with solid protection in the event of a downturn



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