Chimera: Protecting a High Yield Stock From Market Risk Using Options

Mar. 8.11 | About: Chimera Investment (CIM)

A number of investors are looking for income through high yield with relative market risk safety. That is often a difficult combination to achieve. Companies that qualify as real estate investment trusts (REITs) are good income producers, but they are not immune from market and / or interest rate risk.

The use of options to assist us as a tool in the decision to invest is akin to the use of a hammer and nails in constructing a structure. Often for us, the ability to apply option trading techniques is the difference between a viable and non-viable trade or investment. It is almost always a key component of our strategy to control risk in any trade, because controlling risk is the cornerstone of successful investing.

Chimera Investment Corporation is one REIT which pays a quarterly dividend that annually yields 16%. Its business is described on its website as follows:

Chimera Investment Corporation is a specialty finance company that acquires and manages residential mortgage-backed securities (RMBS), residential mortgage loans, real estate-related securities and various other asset classes. Our objective is to provide attractive risk-adjusted returns to our investors over the long term, primarily through dividends and secondarily through capital appreciation. We have elected to be taxed as a real estate investment trust (REIT) for federal income tax purposes. We are externally managed by Fixed Income Discount Advisory Company (FIDAC), a wholly-owned subsidiary of Annaly Capital Management, Inc. (Annaly).

According to J3 Information Services Group, in February the President and CEO, Matthew Lambiase increased his holdings in the company by over $200,000 at a share price of 4.18. We consider insider buying an important leading indicator of a company's prospects.

On the other hand, the stock is one of the relatively weaker securities in the overbought real estate sector. Yet, CIM has been slowly and methodically trending upward, and it is poised to break out if it prints 4.50 on a point and figure chart. The stock presently trades at 4.25 as of the close on March 4, 2011. The stock is not a big mover, either up or down, but that may not be a bad thing. A profitable investment need not be anything other than boring. If harder times are coming, there may be no steadier way to make money in the markets.

However, if those hard times are accompanied by higher interest rates, REITs-- including CIM-- may not fare so well. In fact, the risk to buying this stock is if QE2 ends with no sequel, causing the general market and interest rate sensitive stocks to sell off.

How can we protect this yield (assuming the company continues the dividend), and substantially protect our position from a general market sell-off with the use of options? Here is how we do it:

  • Buy CIM stock at 4.25 or better;
  • Buy CIM September 4.00 puts to cover the stock at .30 cents per contract

This may work out as follows. Sometime between now and June our benevolent FED may make announcements that will reveal its intent to continue easing (or not). The market will either sell off, go up, or do nothing. Should the stock price of CIM react negatively to the news, the puts will afford protection below 4.00 per share. Therefore, until mid-September, our risk is limited to .55 cents (the cost of the puts plus the difference between the entry price and strike price).

By buying the September puts, we will have a few extra months of time value to evaluate any necessary adjustments that we may deem appropriate after the dust settles. This may include selling the puts to take a profit on them, continuing to hold, selling puts at a lower strike price or overhead call to take advantage of higher implied volatility to pay for the puts we purchased, and so on.

The idea is to protect an income producing stock from market risk when it may be apparent that the risk of continuing to hold is increasing. Anyone already holding CIM or similar income producing stocks that trade options may want to consider a similar plan to protect against the risk of severe market decline. Income from dividends are not much comfort if the stock declines significantly below the purchase price with no protection in place. Based upon what happened in 2008, the risk is real.


Disclosure:
I have no positions in any stocks mentioned, but may initiate a long position in CIM over the next 72 hours.