Risk Management Options Strategies For Income Investors In Uncertain Times

 |  Includes: JNJ, KMP, MO, NLY, PM, SO, T
by: Parsimony Investment Research

Despite the recent rally in U.S. equities to start the year, we think investors should remain cautious due to the underlying economic headwinds the U.S. continues to face. We think that the economy will continue to see subpar growth that will hinder the employment market and continue to create uncertainty. The current headwinds include:

  • High levels of unemployment

  • Weak housing market

  • Subpar economic growth

  • Rolling European debt crisis

  • Uneven growth rates in China

  • Increasing polarization in U.S. politics

  • Increasing cutbacks on state and local government spending

  • European austerity measures

We think that while investors should remain cautious, an overweight position in cash and government debt is unwarranted given low nominal yields and valuations. Instead, we believe income investors should utilize option income strategies to generate additional income while mitigating downside price risk in their dividend stock portfolio.

We outline a few strategies below that investors can deploy in a low growth, uncertain environment.

In general, low beta dividend stocks are ideal for option income strategies. 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 volatility with these strategies, you want actual volatility to remain low after you execute your strategy. Low beta stocks are less likely to surge (in either direction), 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: Johnson & Johnson (NYSE:JNJ)

  • Consumer Staples: Altria (NYSE:MO), Philip Morris Intl. (PM)

  • Utilities: Southern Company (NYSE:SO)

  • Telecom: AT&T (NYSE:T)

  • Mortgage REITs: Annaly Capital (NYSE:NLY)

  • MLPs: Kinder Morgan Energy Partners (NYSE:KMP)

Strategy 1: Sell Covered Calls into Market Strength

Investors can augment their dividends by selling out of the money calls on their existing dividend stock portfolio. With this strategy, investors can retain their stock and retain their dividend.

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.

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 1.7%, with a margin of safety of 4.7% and upside potential of 8.7%.

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Strategy 2: Sell Cash-Secured Puts

We think that selling cash-secured puts on high-quality dividend stocks is a perfect strategy for a conservative income investor in a down market. It allows investors to generate income while patiently waiting for a better entry price.

If you sell a put, you have an obligation to purchase the stock at a predetermined price (strike price) on or before the expiration date (if the buyer of the put option wants to sell you the stock). Clearly, the risk is that the stock drops significantly below the strike and you are forced to buy the stock at a price above market.

Here are our two risk management rules of put selling:

  1. Only sell put options on stocks that you want to own at the price you want to own them - With a put selling income strategy (focused on out-of-the-money puts), you get paid to wait for the price you want on a stock. If the price never drops to your strike, you get to keep the premium (income) as a consolation prize. Your downside is owning the stock at the strike price (keep that in mind as you analyze the ideas below).

  2. Don't sell "naked" - Just because options offer you leverage, it doesn't mean that you have to use the leverage. We recommend securing your short put position with cash (i.e., don't sell on margin). If you aren't willing to risk the cash to back it up ... don't sell the put!

Below are the specific put options that we would recommend selling on the same stocks that we highlighted above. On average, the 6-month yield is 2.4% with a margin of safety of 11.4%.

Disclosure: I am long MO, NLY, T, JNJ, KMP, PM, SO.