Insuring High Dividend Securities - Good Idea Or Waste Of Time?

| About: Annaly Capital (NLY)

As you may be able to tell I am a fond proponent of protecting stock positions with long term married puts, dynamic collars and standard collar positions. The implementation of the unique form of a married put trade came about when we partnered up with RadioActive Trading. These techniques start off with a protected position that only risks single digits and then eleven different income methods can be used over time to lower the initial at risk, generate further income and potentially bulletproof the position (meaning there is no risk and still upside profit potential).

As we share these techniques with investors we are commonly asked: "Can I use this setup on a high-dividend security in order to effectively cancel all the risk from the beginning?"

The answer is yes, but there is always a catch.

The basic setup of this unique form of married put position is that to purchase stock and at the same time purchase a put option that is at least 5 months out in time and one or two strikes in-the-money. This setup typically guarantees that we are not risking more than 3-8% of the invested capital.

If a put option is purchased 12 months out in time in a married put position, carrying a risk of 5% and the underlying security pays an annual dividend of 5%, would we consider the position bulletproof?

Yes, assuming some basic points:

  1. The underlying company does not reduce or cancel the dividend

  2. We remain in the security for the entire 12 month period

If we apply any adjustments to generate income over the next 12 months that would be extra money in our pocket. If it is that simple, wouldn't we do better with a security that pays a higher dividend rate, say 10, 12 or 15%? In order to answer these questions I opened a RadioActive Trade for Annaly Capital Management Inc. (NYSE:NLY). Here are the trade specifics:

December 21st, 2011

Buy to Open 100 shares of NLY @$16.70

Buy to Open 1 2013 JAN 17.50 put @$ 3.45

Total Investment = $20.15

Guaranteed Exit from Put = -$17.50

Total Amount At Risk = $ 2.65, or 13.2%

Annaly Capital Management Inc. is a high yielding REIT. At the time the married put was opened NLY paid an annual dividend of 13.6%. I had mentioned that we normally look for positions that have between a 3-8% at risk, so why did we take such a high risk with this position? The high dividend amount for the underlying security is priced into the long term put option. We could have had a lower at risk amount by purchasing a put option that was deeper in-the-money but this would have lowered our expectancy of profit. As it turns out, the expectancy for profit turns out to be fairly low when one insures a high dividend yielding security.

Over the course of the last 11 months I looked for opportunities to generate income or adjust the married put following the RadioActive Trading principles. However, there were two road blocks in my trading approach that are common with high yielding securities:

  1. Short term call and put premiums on high yielding securities are very low. At times it does not make sense to simply sell a call if the premium is only $0.10 for the at-the-money call option.

  2. We do prefer to see some growth in the underlying security in order to realize profit or have a better opportunity to make adjustments. Securities that pay a double digit dividend tend not to have a lot of volatility or price movement.

The trading range for NLY during this time frame was a high of $17.75 (seen on September 12th, 2012) and a low of $15.32 (on November 6th, 2012).

The high was a 6.3% increase from our purchase price of $16.70 and the low represents a decline of -7.2% from the purchase price. During the first few months of the trade Annaly Capital Management Inc. stayed within a tight trading range between $16.00 and $17.00 per share, so we did not see the growth we were hoping for in the underlying security.

We have collected four dividend payments to date totaling $2.17 per share, or an average of about $0.54 per payment.

Here are the current prices for NLY after close on November 6th, 2012:

NLY closes @ $15.32

JAN 2013 17.50 put @ $ 2.54

Total dividends received = $ 2.17

Liquidation value = $20.03

Original cost basis = -$20.15

Liquidation loss = -$ 0.12

The NLY married put has an unrealized loss of -$0.12, or about -0.6% when we include the dividends received. Had we simply purchased NLY without the protective put we would have an unrealized loss on the security of -$1.38 per share ($16.70 original stock basis - $15.32 current price). However, we still would have received the $2.17 in dividend payments resulting in an unrealized gain of $0.79 per share, or 4.7%.

This trade solidifies our thoughts that trading this unique form of married put on securities that pay a high dividend may not be the best approach. The high dividend is priced into the protected put cost, countering the dividends received. High dividend securities do not show a lot of movement, meaning that expected profits from growth are limited. This also leads to a reduction in volatility meaning that it is more difficult to generate additional premium through option selling against the security or other income methods.

That being said, we have had success with married put trades on stocks that pay a more reasonable dividend such as Kraft Foods Group Inc. (KRFT), Johnson & Johnson (NYSE:JNJ) and others. In our next article we will discuss the criteria we use for identifying these unique married put positions on stocks with our desired dividend payment range as well as potential for growth.

Disclosure: I am long NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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