Protecting Your Profits And Yield In A Downturn

Includes: AEE, AGNC, BMY, ED, KMB, MO, NLY, PFE, PM, T
by: Parsimony Investment Research
2011 was a volatile year for most investors. While the indices ended essentially flat, the equity markets experienced two significant drawdowns (20%+) during the year. As 2012 starts off on a high note, investors should remain cautious and consider ways to hedge a portion of their profits (and income) from risk of slowdown in 2012.

Macro Risks Remain

Investors have a significant amount of macro risk to consider including:

  • Start of QE3
  • A relatively weak economic recovery
  • Stubbornly high level of unemployment
  • Weak housing market
  • U.S. debt ceiling
  • Fiscal issues at the state and local level leading to cutbacks
  • Lingering European credit issues
  • Rising in commodity prices
  • And the list goes on.

The S&P 500 is up over 4% to start the year. However, as highlighted in the chart below, some bearish technical signals are starting to show:

First of all, the S&P seems to be forming a rising wedge, which is a bearish chart pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows. Also, there has been a bearish divergence in the MACD. Even though the index broke the recent high from November, the MACD failed to make a new high. In addition, the S&P has the highest RSI reading (67.8) since July 2011, which was just prior to the 20% pullback in August 2011.

The Components of Total Return

The total return on a dividend stock has two main components: (1) the dividend yield and (2) the change in stock price. Most of the time both of these components have a positive effect on your total return. However, a significant price decline can literally "wipe out" years of dividends, resulting in a negative total return.

The price fluctuation in a dividend stock cannot be ignored. While dividends have accounted for over 40% of the total annual return of the S&P 500 since 1926, over 100% of the returns over the past 10 years were attributed to dividends (meaning the return on the underlying stock was negative).

That said, dividend stock investors that would like to enhance the yield on their investments (to help offset the potentially negative fluctuations in stock price) should consider implementing a covered call strategy. A covered call strategy will add a third component to the total return of a dividend stock and will increase the probability that the investment will have a positive total return over time.

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

In general, low beta dividend stocks are ideal for a covered call strategy. Stocks with low betas will tend to be less volatile than the general market and should hold up relatively well in a market downturn. Since you are selling upside volatility with a covered call strategy, you want actual volatility to remain low after you write a covered call on your dividend stock position. Low beta stocks are less likely to surge to the upside in a short term rally, making the probability of assignment lower.

For this analysis, we focused on stocks in sectors that hold up well in a slow-growth economic environment.

  • Health Care: Bristol-Myers Squibb (NYSE:BMY), Pfizer (NYSE:PFE)
  • Consumer Staples: Altria (NYSE:MO), Kimberly Clark (NYSE:KMB), Philip Morris Intl. (NYSE:PM)
  • Utilities: Ameren Corp. (NYSE:AEE), Consolidated Edison (NYSE:ED)
  • Telecom: AT&T (NYSE:T)
  • Mortgage REITs: American Capital Agency (NASDAQ:AGNC), Annaly Capital (NYSE:NLY)

Choosing the Right Strike

There are three key components to look at when choosing a strike price for a covered call strategy:

  • Premium Yield (%) - The additional yield generated by the call premium (which is your downside protection from the current price). An investor should typically target a 1.5%-3.0% premium yield for options with 4-6 month expirations.
  • 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. An investor should target a minimum margin of safety of 4% or more (depending on the volatility of the stock).
  • 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. An investor should target at least a 6% upside profit potential for this strategy.

Protect Your Profits and Dividend Yield

Below are the specific call options that we would recommend selling on the candidates that we highlighted above. On average, the 6-month premium yield is 1.9%, with a margin of safety of 5.4% and upside potential of 9.9%.

Disclosure: I am long MO, AGNC, NLY, T.