We recently wrote an article highlighting our "Buy Zones" for some large cap diversified MLPs.
Due to the current market rally and the attractive dividend yields in the MLP space, the Alerian MLP Index (NYSEARCA:AMLP) is up about 25% from the lows in October 2011.
While we think the long-term fundamentals are very positive for the MLP industry, we believe that a significant general market pullback is imminent. As such, the MLP stocks may also experience a significant pullback.
The Dividend Investor Dilemma
A situation like this creates quite a dilemma for a dividend investor. Obviously, the dividend investor's main investment goal is to realize consistent, stable income throughout the market cycle. However, its often difficult to maintain composure and discipline when a pullback is on the horizon. The dividend income doesn't feel as so good when the stock is down significantly.
Defensive Put Strategy
One risk management strategy that we often employ at a time like this is what we call the Defensive Put Strategy. With this strategy, you sell your dividend stock at current levels and simultaneously sell a cash-secured put with an out-of-the-money strike price to maintain an income stream from the stock.
Below are details of a defensive put strategy for a widely held large cap MLP: Enterprise Products Partners (NYSE:EPD).
As shown in the chart above, our ideal "buy zone" for EPD is $43.00-$45.00 as we believe the stock will get strong support around this level on a dip. Note that this buy zone is approximately 12% below the current market price.
Here are the details of the defensive put trade:
- Sell Stock at Current Price: $50.39
- Sell June 2012 $46.00 Put: $0.90 (premium)
- Break-Even Price: $45.10
- Margin of Safety: 10.5%
- Premium Yield: 2.0%
- Lost Dividend Yield: 1.3%
We think that the Defensive Put Strategy is a perfect strategy for a conservative income investor in a down market. It allows investors to continue to generate income while mitigating downside price risk.
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). This is why you only sell put options on stocks that you want to own at the price you want to own them.
In the case of EPD, you would sell a put option that would give you a break-even price ($45.10) close to our ideal "buy zone" ($43.00-$45.00). In addition, the put trade generates a yield of 2.0% (if the stock stays above the put strike price), which is higher than the expected dividend yield (1.3%) between now and the June expiration.
As you can see, this strategy significantly reduces downside price risk without sacrificing the dividend yield. After expiration, the investor can then reassess the market conditions and decide whether or not to open a new position in the stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Short EPD June 2012 $46.00 Puts.