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Even after the recent rally treasury yields remain low. Fortunately, volatility has also dropped, affording opportunities to construct treasury-beating option strategies on dividend stocks.

The simultaneous purchase of a stock, writing a call option, and buying a put option creates the option strategy known as a collar. This strategy has limited upside and downside, which if constructed carefully on the right stocks is more attractive than buying a treasury. Several dividend paying natural resource sector stocks were used to construct collars, thereby providing a means to beat Treasury bond payouts. The following criteria were taken into account for comparison with the 10-year treasury:

Higher yield. The options strategy must provide a higher yield than the 10-year treasury on the net initial investment. To this end, stocks were selected which have a higher dividend yield than the 2.23% bond equivalent yield of the 10-year treasury. Stocks were also screened for payout ratios under 0.50 to allow for dividend growth or slack in the event of a downturn.

Better upside potential. The option strategy must allow for more appreciation in the value of the total position than is available to the 10-year treasury. Based on the current rate, a 10-year treasury bond would appreciate 11.7% if its bond equivalent yield dropped to 1%. Thus, the option strategy must allow for a 11.7% appreciation in price.

Better downside protection. The put component of the strategy must limit the potential loss of the position to less than could be lost in the treasury if interest rates bump up to 5%. Based on the current rate, a 10-year treasury bond would drop 21.6% if its bond equivalent yield rose to 5%. There is the possibility of even more downside in treasuries from further rate increases, but this is a good number to start with.

The following four stocks were found to provide the right mix of dividend yield and available options to construct attractive collars:

Ticker

Company

Industry

Dividend Yield

Payout Ratio

CLF

Cliffs Natural Resources Inc.

Steel & Iron

3.53%

0.07

COP

ConocoPhillips

Major Integrated Oil & Gas

3.45%

0.29

CVX

Chevron Corporation

Major Integrated Oil & Gas

3.05%

0.23

DD

E. I. du Pont de Nemours and Co.

Chemicals - Major Diversified

3.12%

0.44

Stock and option prices for each are provided below:

Ticker

Call Bid

Call Strike

Call Expiration

Put Ask

Put Strike

Put Expiration

Stock Price

CLF

6

80

Jan 2013

6.55

60

Jan 2013

70.78

COP

1.34

87.5

Jan 2013

2.77

65

Jan 2013

76.51

CVX

1.32

125

Jan 2013

5.4

95

Jan 2013

106.36

DD

1.35

60

Jan 2013

2.57

45

Jan 2013

52.63

The combination of buying the stock, selling the call, and buying the put creates the following payout and adjusted dividend yields:

Ticker

Position Net Cost

Max Value

% Gain

Min Value

% Loss

Adjusted Div Yield

CLF

71.33

80

12.15%

60

-15.9%

3.50%

COP

77.94

87.5

12.27%

65

-16.6%

3.39%

CVX

110.44

125

13.18%

95

-14.0%

2.94%

DD

53.85

60

11.42%

45

-16.4%

3.05%

Consider the options strategy suggested for DD. Instead of buying the stock alone for $52.63 and hoping that swings in the stock price will not overwhelm its 3.12% yield, an investor could opt to create a collar.

The collar could be created through the purchase of DD stock for $52.63, buying the put at $2.57, and selling the call at $1.35. The net cost of this position is $53.85, which is only $1.22 higher than buying the stock by itself. The benefit of the additional option trades is a floor on losses, which are limited to 16.4%. The yield on this slightly more expensive position is 3.05%.

Each of these positions has less downside and more upside in capital appreciation than a 10-year treasury based on 5% to 1% interest rate scenarios. Furthermore, each of these stock collar positions provides a higher yield which could benefit from increases in dividend policy. Fixed income investors should consider these positions as attractive alternatives to bonds which are subject to interest rate risk.

Source: Attractive Yields From Collar Option Strategy On Natural Resource Stocks