The most frustrating thing about holding a stock is that it isn’t a bond. This may sound obvious, but any income-focused equity investors out there will understand my nuance. When you buy a high-yielding equity, you’re still greatly exposed to the capital fluctuations of the price itself. Even if the stock pays out a 10% yield every year, you’re still in the red if the market crashes and the stock drops 20%.
As a small-time investor, we don’t have the wherewithal to deal with these sorts of fluctuations. Volatility is destructive to our livelihoods, and is the enemy of income planning. Wouldn’t it be nice if we could just take our dividends and leave the speculation to the computer-cowboys at the hedge funds? Let me show you a little trick I use to protect my high-yielding positions when I’m not really confident in the overall market.
Suppose an investor wanted to benefit from XYZ company’s 10% dividend yield, but was afraid that the coming year’s market conditions were going to be sloppy enough to negate those returns. However, the investor’s advisor is confident that the company’s earnings are strong enough to support the continued payout of the 10% dividend. This presents the investor with a fantastic opportunity to obtain high-yield bond-like returns from an equity asset, without having to worry about dramatic price fluctuation from the overall market. Once again, the value of a hedged option position is going to prove its value to our hypothetical investor.
In order to gain exposure to the 10% dividend, the investor needs to purchase the stock. Given the volatility of the market, the insightful investor will purchase in increments of 100 units, in order to easily hedge the position afterwards. Once having purchased the position, the investor will then purchase a 12 month put option on the position, allowing them the right to sell the stock at the current market price, or maybe even a little bit less. The investor will have effectively hedged their exposure to the dividend, and purchased away any risk of capital fluctuation.
However, our investor needs to be careful that they don’t spend the entire value of the dividend away on the risk-premium of the option. Usually when engaging in this sort of transaction, the investor’s advisor can help them to build a spreadsheet that will price out exactly which put contract will leave the most of their dividend intact, while providing the greatest possible hedge in purchase price.
While this may reduce the effective return by as much as 5% in this situation, the end result is a secured 5% return for the rest of the year, while also retaining any upside exposure that may become valuable should XYZ gain in value over the year.
By now, you should have a sneaking suspicion that there’s a better way for a personal investor to engage in this sort of transaction. Paying out half of your dividend yield is hardly an ideal situation for a personal portfolio. Couldn’t that money be better spent towards paying bills? As personal investors, we should always be averse to positions that require us to put more cash at risk. As a general rule, money-risks are better held by large banks. Our personal portfolios, on the other hand, should be focusing on value realization over time. In the next article, I’ll show you a trick to reversing this transaction so that our hypothetical investor can hedge their position, and even increase the overall yield associated with their position in XYZ.
