THE DOWNSIDE OF A DIVIDEND STOCK
Dividend stocks offer great income potential and tend to be more stable (and less volatile) compared to their non-dividend paying counterparts. However, these stocks are not risk-free and are still subject to systematic (market) risk.
What can an investor do to help protect their dividend yield in a market downturn
Systematic risk can be mitigated only by being hedged. Income investors that are weary of near-term downside price risk can use a covered call strategy to generate additional income, which will help hedge this systematic risk and help protect their dividend yield.
COVERED CALL BASICS
Source: Options Industry Council
The covered call is a strategy in which an investor writes a call option contract (for an equivalent number of shares) on a stock that the investor already owns. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership.
Though the covered call can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.
While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.
As expiration day for the call option nears, the investor considers three scenarios and then accordingly makes a decision. The written call contract will either be in-the-money, at-the-money or out-of-the-money. If the investor feels the call will expire in-the-money, he can hope to be assigned an exercise notice on the written contract and sell an equivalent number of shares at the call's strike price. Alternatively, the investor can choose to close out the written call with a closing purchase transaction, canceling his obligation to sell stock at the call's strike price, and retain ownership of the underlying shares. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock. If the investor feels the written call will expire out-of-the-money, no action is necessary. He can let the call option expire with no value and retain the entire premium received from its initial sale. If the written call expires exactly at-the-money, the investor should realize that assignment of an exercise notice on such a contract is possible, but should not be assumed.
IDEAL CANDIDATES FOR A COVERED CALL STRATEGY
Below is a list of defensive stocks (healthcare, utilities and consumer staples) with high dividend yields (> 3.0%). Since these stocks will likely hold up relatively well in a market downturn, they are ideal candidates for a covered call strategy.
Note: I think the ideal timeframe for a covered call strategy is 6-12 months (and I used the Jan 2012 expiration month for each option in this analysis for consistency).
HIghlights from the table below:
- Premium Yield (%) - In most cases, the additional yield generated by the call premium is 3%-5% (which is your downside protection from the current price).
- Margin of Safety (%) - The margin of safety is the amount that the stock would have to drop from the current level (before expiration) to completely offset the call premium and the dividend yield. Most of the stocks in this analysis have a margin of safety over 6%.
- Upside Profit (%) - The upside profit, which assumes that the option is assigned at expiration, is equal to the premium received + dividends received + the difference between strike price and current price. Most of the stocks in this analysis have an upside profit potential over 10% (which isn't bad for an 8-month return).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.