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Mortgage REIT (MREIT) investors can utilize equity-options to provide downside protection on the common stock price. We can explore option strategies to provide an ideal risk and reward equation for your personal circumstances. Every investor has a specified risk tolerance, and options can mitigate a certain degree of MREIT common share risk.

If you want to explore the option world, I highly recommend the book, "Options as a Strategic Investment," by Lawrence G. McMillan. This is a must-own book to fully understand the option world. I'll discuss a few basic option terms and how to implement these strategies in the MREIT equity space.

There are two basic option types: calls and puts. Calls represent the right to buy 100-shares of a security [eg, Microsoft (NASDAQ:MSFT)] at a predetermined strike price (eg, $25 per share). This contract is in effect through the expiration date, which could be from one-day in duration to three years in duration. A "naked call" represents owning only the call option. Selling a "covered call" requires owning the stock and selling a call against the long common stock position.

Puts represent the right to sell 100-shares of a security at a predetermined strike price. This contract is in effect from one day to three years. These variables are all known prior to purchase of the put option. A "naked put" represents owning only the put option. A protective put is owning the common shares and a long put option. The put option provides a floor on the maximum transaction loss.

Selling a covered call requires selling 1-call contract, for a specified strike price, thru a specified time period. 1-call contract equates to 100 common stock shares. Equity options expire on the third Friday of the respective expiration month. Selling a covered call explicitly means you must be willing to give up your shares at the predetermined price if the stock moves above the strike price. The investor will receive the covered call premium and the strike price per share.

Buying a protective put requires buying 1-put contract, for a specified strike price, through a specified time period. A 1-put contract equates to 100 common stock shares. Equity options will expire on the third Friday of the put expiration month. Purchasing a naked put contract provides the put owner the right to sell 100-shares of the respective stock at the specified stock price through the expiration time frame. A long position in a naked put implies an investor's confidence the equity will decrease in value. A long protective put position, however, is designed to provided a floor to the maximum transaction loss.

Long-term Equity AnticiPation Securities (LEAPS) are options which can extend to 3-years in duration. Option values decay with time. A longer duration option, all things being equal, has more intrinsic value than a shorter duration option.

Investors should consult with their tax advisers pertaining to the tax implications created by equity option gains or losses.

American Capital Agency (NASDAQ:AGNC)

  • AGNC Stock Price: $30.15
  • Covered Call Strategy: sell a covered call July 2011 $30 strike
  • Naked Put Strategy: purchase a naked put Jan 2013 $25 strike

Equity Position

For purposes of option-equity simplicity, I will assume the investor owns 1,000 shares of AGNC. The value is $30,150. The expected dividend income is $5,600 per year.

Option Position

Let's be conservative and buy 10-put options, which would provide downside protection on the 1,000-AGNC common shares. The put option (symbol: AGNC130119P00025000) will legally contain the following details: common stock symbol is AGNC; option expiration is January 19, 2013; strike price is $25.00. Hypothetically this trade will cost $4.50 per contract, or a total of $4,500. This is a debit transaction to your brokerage account.

To offset the $4,500 cash outlay, let's sell 10-call options. This will represent the 1,000-AGNC common shares. The call option (symbol: AGNC110716C00030000) will represent AGNC common shares; the options will expire on July 16th, 2011; and have a strike price of $30-per share. We will receive $30 per contract or a net credit of $300. The option trade is still $4,200 in the red, but we are hedged on our common stock.

The above two transactions can easily be placed simultaneously. I separated each component to illustrate the net impact of each transaction upon your MREIT holdings.

Dividend Yield

AGNC currently pays a $1.40 quarterly dividend per AGNC-share. AGNC, on June 10th, confirmed the 2nd quarter dividend. The annual dividend is $5.60 per share. AGNC presently offers shareholders an annualized 18.56% dividend yield.

Net Position

We own 1,000 shares of AGNC. The total cost is $34,350. This includes the $30,150 for the AGNC shares plus $4,200 for the net debit option trade. The annual dividend, assuming the options are not exercised or sold, proves a still attractive 16.3% annualized dividend yield on total cost basis of $34,350.

AGNC owners, as of June 21st, will receive a $1.40-dividend per share or $1,400 payable on July 27th.

In the worst-case scenario, if AGNC goes to $0-per share, the total loss will be $7,950. The math involved is: [($30,150-stock cost) + ($4,500-put option) - ($300 credit received for call option proceeds) - ($1,400 dividend on July 22nd) - ($25,000 put option value if AGNC goes to $0)]. The put options would be worth $25,000 and the total net cost was $34,350.

AGNC will drop in value on June 21st when the ex-dividend occurs. Either the short July $30 call position will expire worthless or we can roll it over to the next month.

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Annaly Capital Management (NYSE:NLY)

  • NLY Stock Price: $18.42
  • Covered Call Strategy: sell a covered call October 2011 $19 strike
  • Naked Put Strategy: purchase a naked put Jan 2013 $15 strike

Equity Position

Let us assume we have a 2,000-share position in NLY. The value is $36,840. The expected dividend income is $4,960 per year. This is based upon a regular 62-cents quarterly dividend.

Option Position

Let's continue to mitigate risk and buy 20-put options, which would represent the 2,000-NLY common shares. The put option (symbol: NLY130119P00015000) will possess the following details: common stock symbol is NLY; option expiration is January 19, 2013; strike price is $15.00. Hypothetically this trade will cost $1.90 per contract, or a total of $3,800.

To offset the $3,800 cash outlay, let's sell 20-call options. This will represent the 2,000-NLY common shares. The call option (symbol: NLY111022C00019000) will protect the downside maximum loss of the NLY common shares; will expire in October 2011; and have a strike price of $19-per share. We will receive $11 per contract or a net credit of $220. The option trade is still a net $3,580 debit, but we are hedged on our NLY common stock.

Dividend Yield

NLY currently pays a 62-cent quarterly dividend per NLY-share. The annual dividend is $2.48 per share. NLY presently offers shareholders an annualized 13.46% dividend yield.

Net Position

We own 2,000 shares of NLY. The total cost is $40,640. This includes the $36,840 for the NLY shares plus $3,580 for the net debit option trade. The annual dividend, assuming the options are not exercised or sold, proves a still attractive 12.2% annualized dividend yield on a total cost basis of $40,640.

In the worst-case scenario, if NLY goes to $0-per share, the total loss will be $9,180. The math involved is: [($36,840-stock cost) + ($3,800-put option) - ($220 credit received for call option proceeds) - ($1,240 dividend for the expected NLY 2nd quarter dividend) - ($30,000 put option value if NLY goes to $0)]. The put options would be worth $30,000 and the total net cost was $34,350. If you include the NLY 2nd quarter dividend total of $1,240, the worst case scenario is a $9,800 aggregate loss.

NLY will drop in value during the 2nd quarter when NLY-common stock goes ex-dividend. Either the short October $19 call position will expire worthless or we can roll it over to a future month.

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Hatteras Financial (NYSE:HTS)

  • HTS Stock Price: $28.52
  • Covered Call Strategy: sell a covered call Aug 2011 $29 strike
  • Naked Put Strategy: purchase a naked put Jan 2013 $25 strike

Equity Position

I will assume the investor owns 1,000-shares of HTS. The value is $28,152. The expected dividend income is $4,000 per year.

Option Position

Let's continue to be conservative for this exercise. We will buy 10-put options to safeguard against the entire 1,000-HTS position. The put option (symbol: HTS130119P00025000) will possess the following details: common stock symbol is HTS; option expiration is January 19, 2013; strike price is $25.00. Hypothetically this trade will cost $4.40 per contract, or a total of $4,400. This is a debit transaction to your brokerage account.

To offset the $4,400 cash outlay, let's sell 10-call options: strike price $29; expiration August 2011. The call option (symbol: HTS110820C00029000) will represent the entire 1,000 HTS common shares. We will receive $30 per contract for a net credit of $300. The option trade is still $4,100 ($4,400 - $300 = $4,100) in the red, but we are hedged on our HTS common stock.

Dividend Yield

HTS currently pays a $1.00 quarterly dividend per HTS-share. HTS, on June 15th, confirmed the 2nd quarter dividend. The annual dividend is $4.00 per share. HTS presently offers shareholders an annualized 14.00% dividend yield.

Net Position

We own 1,000 shares of HTS. The total cost is $32,620. This includes the $28,520 for the HTS shares plus $4,100 for the net debit option trade. The annual dividend, assuming the options are not exercised or sold, proves a still attractive 12.2% annualized dividend yield on total cost basis of $32,620.

HTS owners, as of June 23rd, will receive a $1.00-dividend per share or $1,000 payable on July 22nd.

In the worst-case scenario, if HTS goes to $0-per share, the total loss will be $6,620. The math involved is: [($28,520-stock cost) + ($4,400-put option) - ($300 credit received for call option proceeds) - ($1,000 dividend on July 22nd) - ($25,000 put option value if HTS goes to $0)].

HTS will drop in value on June 23rd when the ex-dividend occurs. Either the short August $29 call position will expire worthless or we can roll it over to a subsequent month.

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Source: Hedging Mortgage REITs With Options