Atlas Pipeline Partners: Hedged Income Strategy

Consider this suggestion for income using a collar to hedge the downside risk. First some background on collars.

Collar

A collar is a covered call with an additional long put to protect the downside of the long stock. If we buy a stock because it pays good dividends our objective is income. One reason the dividends could be attractive is the result of an abnormal decline in the stock price causing the dividend rate to rise. If the fundamentals remain intact then the dividend rate could be unusually attractive. However, in order to take advantage of the temporary stock price decline we are faced with the dilemma of buying a stock that has been going down in price and may not have yet stabilized or begun to turn higher. A collar is one way to go ahead and buy the higher paying dividend stock and protect the downside risk. The collar is created by selling an out-of-the-money call and then using the proceeds to purchase an out-of-the-money put.  Ideally, the call sale will cover most or all of the put cost. If the stock stays within bounds of the collar we keep the stock and collect the dividends. If the stock rises above our sold call price we will lose the stock by assignment at expiration, but make a gain on the stock sale price. If the stock declines we have downside protection from our long put. 

Currently there are at least two sectors that are not financials, offering such opportunities: shipping and pipelines. 

Here is an interesting suggestion for collaring income.

Atlas Pipeline Partners LP (APL) 29.55. APL engages in the transmission, gathering, and processing of natural gas with an extensive gas-gathering infrastructure serving the heart of the most active region of Marcellus shale formation. With a current dividend of 12.7% they have already guided to a higher dividend rate for the balance of the year and advised that the dividend will be covered 1.3 times by the available cash flow. Further they guided 2009 distributions to 4.25 to 4.50 for a current rate of almost 15%. Insider open market purchases are always a good indicator - the Chairman & CEO bought 10,000 shares of stock on August 12, 2008 at 33.47.

With the current emphasis on the growing role of natural gas as a transportation fuel being promoted by T. Boone Pickens and others this appears to be a good opportunity without exploration and production price risk.

With a current Historical Volatility of 36 consider this collared stock purchase for income.

• Buy 100 shares APL at 29.55
• Sell APL Nov 25 call APLKG .25 IV 32.44 Delta -.1166
• Buy APL Nov 25 put APLWE .40 IV 32.90 Delta -.1507

Options debit .15 Options net delta -.2673

Position net debit 29.70 Position net delta .7327 

We suspect commodity related hedge fund selling for the recent excessive decline in this sector, but expect the price should now stabilize and turn higher before very long. In the event it continues lower the position is protected to some degree by the long Nov 25 put.

Disclosure: As yet I do not have any positions in APL.

Comments

[the eck:]

While the strategy makes a lot of sense, there is an error in the example. A Nov 25 call is not out of the money but very much in the money. the author may mean a Nov 35 call.

2008 Sep 15 06:14 AM

[Joe Red:]

test

2008 Sep 15 11:29 AM

[Joe Red:]

If the stock is called @$25 you will lose $455 and the cost of the collar. You may receive a dividend if one is paid by the third week of November.

2008 Sep 15 11:33 AM

[User 184146:]

Somewhere in translatoin we lost the strike price. The correct strike is NOV 35 for the symbol APLKG.

Jacktraker

2008 Sep 15 12:49 PM

[rcraig:]

With the market going as crazy as it is I would venture to say many investors are going to go long on any stock which pays a dividend or is in alternative energy production or natural gas transfer.
I keep crossing my fingers and hope some of the corporate executives responsible for the recent upheaval i the markets will step out on the ledge of the first floor and attempt sucicide. At least we would have some rationaliztion for commiting the to an insane asylum.

2008 Sep 16 12:35 PM