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This is Part 5a of a 5-part series that highlights each step of our recommended investment plan that will help you build and monitor your own DIY Dividend Portfolio.

The Importance of a Proper Investment Plan

Most "do-it-yourself" investors fail miserably over the long term. As a matter of fact, the majority of professional investors fail to beat the returns of the broader market indices every year. That said, there is one common trait that every successful investor shares…an investment plan!

Unfortunately, simply setting up an investment plan isn't enough to succeed these days. You also have to have the discipline to carry out that plan (come rain or shine). Contrary to popular belief, the market does not control your investment success…you do!

While the specific details of a dividend investor's personal investment plan will vary based on age, risk tolerance, etc., we suggest that investors use the plan below as a guide (links to previous parts of this series are highlighted below in blue):

  1. Identify, research, and invest in dividend stocks with the best risk/reward profiles.
  2. Identify low-risk entry points for each stock (i.e., a "Buy Zone").
  3. Adhere to strict asset allocation targets (for asset classes, industries, and individual stocks).
  4. Maintain a disciplined exit strategy for each stock by closely monitoring changes in fundamental and technical data points.
  5. Utilize portfolio hedging techniques and conservative option strategies to manage downside risk (e.g., protective puts, covered calls, and cash-secured puts).

Part 5a: Protective Put Hedging Strategy

Market corrections happen. As a matter of fact, we would add market corrections to the list of things in life that are guaranteed. Just like death and taxes, market corrections are a way of life. That said, investors need to EXPECT, and more importantly, PLAN for major corrections.

Investors can plan for a market correction by taking the necessary steps to hedge their portfolio. In our opinion, a protective put hedge strategy is the easiest and most cost-effective way to hedge a portfolio.

Purpose of Protective Put Strategy

The main purpose of hedging your portfolio is to limit your downside market exposure (i.e., protect your capital base), while keeping your dividend income in tact. As we said above, we believe that purchasing a protective put is the easiest (and most cost effective) way to hedge your portfolio.

Note: If you are unfamiliar with options, there are some great free websites out there to educate yourself (like the Option Industry Council). For the purposes of this article, we assume that the reader has a basic knowledge of options.

Hedging Instrument

We like to use options on the S&P 500 ETF (SPY) for our protective put strategy. Remember that we are only trying to "hedge" the general market exposure in our portfolio and the S&P 500 is a great proxy for the general market. In addition, SPY options are extremely liquid, which makes them very easy to trade.

Note: In our opinion, inverse ETFs, like ProShares Short S&P 500 (SH), should not be used as hedging instruments. Many inverse ETFs have high tracking errors and they tend to use up a significant amount of your capital (since you need to buy enough shares to protect your whole portfolio).

Position Size (How Many Puts Should You Buy?)

So, how many puts should you buy? Every portfolio is different, but the weighted average Beta of your portfolio is a good metric to use to estimate your portfolio's general market exposure (i.e., systematic risk). For example, if your portfolio Beta is 0.50, the volatility of your portfolio should theoretically only be half that of the general market (i.e., if the market declines 1%, your portfolio should only decrease 0.5%).

For simplicity sake, let's say you had a $100,000 dividend portfolio, equally-weighted in the following 10 stocks (with the Betas listed below):

  • Altria Group (MO): 0.42
  • American Capital Agency (AGNC): 0.17
  • Apple Inc (AAPL): 0.91
  • Chevron Corp (CVX): 1.14
  • Johnson & Johnson (JNJ): 0.46
  • McDonalds Corp (MCD): 0.34
  • Procter & Gamble (PG): 0.27
  • Southern Co (SO): 0.12
  • Walgreen Co (WAG): 1.19
  • Wal-Mart Stores (WMT): 0.42

The Betas of these stocks range from 0.12 (Southern Co) to 1.19 (Walgreen) and the weighted-average Beta of this 10-stock portfolio is 0.54. Theoretically, if the S&P 500 declines 10%, this portfolio should only decline 5.4%. That said, below is a calculation of the hedge position:

Underlying Value of 1 SPY Option Contract (SPY Price=$138.16):

$138.16 x 100 = $13,816 (1 contract = 100 shares)

Contracts Needed to Fully Hedge Portfolio:

$100,000 / $13,816 = 7.24 Contracts

Beta-Adjusted Contracts:

7.24 (Contracts) x 0.54 (Beta) = 3.94 Contracts

So if an investor wanted to implement a protective put strategy on the $100,000 portfolio above, they should buy 4 SPY put options.

Note: We have a FREE spreadsheet on our website that will help you calculate the weighted average beta of your portfolio as well as the number of put options you need to implement your hedge.

Strike Price and Term (Expiration)

Other decisions that you have to make when implementing a protective put strategy is choosing the strike price and term of the option.

In general, we prefer shorter term options (less than 3 months until expiration) over longer term options and we prefer "in-the-money" options over "out-of-the-money" options. We have these preferences because we try to limit the "time value" exposure in our protective put. In other words, we want as much "intrinsic value" as possible in our put option. For put options, the intrinsic value is the difference between the strike price and the underlying's stock price and we want the value of our put option to track as closely as possible to the underlying change in the price of SPY. You can see how various terms and strike prices affect the intrinsic value of the option in the table below:

Choosing a strike price and expiration date for your put option is ultimately a personal decision. Some investors may prefer longer-dated options because they have to be "rolled" less frequently or they may prefer "out-of-the-money" options because they are less expensive. However, these decisions will ultimately affect both the cost of the hedge as well as the degree of protection that the protective put will provide. So it is critical that you understand the trade-offs of these decisions before implementing this strategy.

Conclusion

​No hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. Whether or not you decide to hedge your own DIY Dividend Portfolio will depend on your specific market outlook and risk tolerance.

Note to readers: We will be finishing up this series over the next few days with parts 5b (covered calls) and 5c (cash-secured puts), so please make sure to "follow" us.

Source: Building A DIY Dividend Portfolio (Part 5a): Protective Put Hedging Strategy