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The love hate relationship investors have felt with the financial sector has resulted in stock prices that change directions quicker than a cat on Velcro. Those that fear (a further) loss of their investment are quick to push the sell button at the first sign of red. On the other end of the spectrum, those who dread the thought of missing a run frantically chase these stocks like they were catching a bus.

So, would this roller coaster price fluctuation indicate we are in a bear market or the early stages of a bull? While there are bold analysts that remain steadfast to their long horned convictions, anyone who’s taken a look at their portfolio would probably argue otherwise. At a minimum, if in fact we are in a bull market, it’s definitely got its head stuck in a jar of honey.

A commonly utilized strategy in a bear or sideways trading market is to purchase stocks that have a high dividend yield (i.e. pays high dividends relative to price). The logic behind it is simple and intuitive: get paid while you wait. Empirical studies on the performance of dividend versus non dividend paying stocks in down markets have supported this concept.

Yesterday, Allied Capital Corporation (ALD) saw its stock price close at 1.56, after trading between a 52 week high of 21.99 and a low of 58 cents. Put differently, what was once enough to purchase two twelve packs of your favorite brew, is now worth two twelve packs of empty cans. A disturbing fact if you’re thirsty on a Friday night. Even more alarming is Allied Capital’s disproportionate dividend which pays 2.60 a share. With a yield over an astonishing 165%, can Allied Capital be the answer to our bear market woes? Well, not exactly.

If my mother taught me nothing else, she told me never to assume. It’d be naive to assume Allied Capital will maintain its dividends at these egregious levels. Across the markets, firms have been cutting dividends like school bullies in a lunch line. For the first quarter of 2009, Standard & Poor’s reported the number of companies that slashed dividends outnumbered those that raised them. To put this into perspective, the markets had never experienced a quarter where the cuts outnumbered the increases since S & P began collecting this data in 1955. In addition, they recently recorded losses of 1 billion as a result of defaulting on a revolving line of credit. However, on our voyage back to positive levels, even the strongest willed investor may find it difficult to resist the siren song of 165% dividend yield.

While there is little one can do to guarantee receipt of dividends, investors can do more than exercise the buy pray strategy. Suppose an investor is only concerned with Allied Capital’s dividend payment, not the stock itself. An interesting strategy for an investor to speculate on dividend receipt while minimizing price risk can be constructed using the November and January options.

For those unfamiliar with the impact of dividends on stock and option prices, here’s a very quick rundown. When dividends are paid, a stock’s price (theoretically) drops by the full amount of the dividend. In actuality, the price decline is less than the full amount distributed. Concurrently, a call option should decrease proportionately to the dividend payment (which reduces the stock’s price) and a put option should increase by the proportionate amount.

Getting back to Allied Capital, the stock ended the trading session at a price of 1.56. The November 2.50 call options traded with a bid price of .40 and ask of .65, the January 2.50 puts had a spread of 1.35 by 1.50. An investor seeking to capitalize on the receipt of dividends can:

  • Long shares of Allied Capital Stock (ALD) at 1.56
  • Long a proportionate amount of the January 2.50 put options at 1.50
  • Short a proportionate number of November 2.50 call options at .40

Here’s the rhyme behind the reason. An investor that purchases both the 2.50 put options and ALD stock has an unlimited upside potential and his downside capped at 2.50 a share by expiration. However, the total amount paid for this insurance is 3.06 [=1.56 (stock) + 1.50 (put)] meaning there is a potential loss of .56 (=3.06-2.5).

Since the investor is attempting to capitalize on the potential receipt of dividends, we can short the November 2.50 calls at .40. Now, the total amount invested is 2 .66 (= 3.06 - .40), but the investor has locked in the amount due by the November expiration of the calls at 2.50. Therefore, regardless of where the stock is by November, the investor can expect a return of 2.50 and any premium left in the January put options. In the worst case scenario, assuming the January put options are worthless by November, the max loss is 16 cents (= 2.66 - 2.50).

However, besides whatever premiums may be left in the put options, I deliberately chose the November calls, since it provides us with an opportunity to roll the options over to January. Hopefully, the investor is able to short the calls at .16 or more, so that the max loss is potentially reduced to 0, or better yet nothing but gains.

Again, the goal of this trade isn’t to gain from the potential roll of the call options or the residual premiums of the January puts: it’s a means to speculate on dividends receipt at lower levels of risk. If Allied Capital were to maintain their dividend payments, (which again, is a pretty big if) the investor of this strategy would receive 2.60 on a 2.66 investment by January. If the company slashes dividends to zero, the investor’s loss is capped at .16, but even this level has the potential to be dynamically reduced. While there’s nothing wrong with speculating on a stock or potential dividend, it never hurts to look for creative ways reduce your risk while doing it.

Disclosure: no positions

Source: Divided About Allied Capital Dividends