Income Investing Strategy With A Margin For Error

Includes: T
by: Money Investor

Many investors must be wondering how high the market can go, is it to late to buy, and should I sit and wait for a lower point of entry. There is a great battle going on, between the economic reality felt on Main Street, and the bullishness espoused by those on Wall Street. In some regard, this fear of missing the rally may be forcing money into the market at a topping point in the short term. On the other hand, the economic realities facing those on Main Street could shortly find their way to Wall Street, bringing with it a sharp market correction. An investing strategy that I find useful in a market like the one seen today, is to be fully invested for the market to continue to rally if you have that sense of bullishness, but implement a strategy that would allow you to capitalize on a market correction if it were to materialize. One of the most smartest ways to be fully invested in a market such as the one seen today is to own dividend paying stocks that will generate income regardless of short term gyrations in the stock price. Building on that approach, you can fully invest in these dividend stocks through a two part strategy that consists of capturing the dividend yield and generating additional income through another type of trade.

I like to think of this approach as my 50/50 strategy when investing in dividend yielding stocks. Out of the total I desire to invest in a certain company, I would allocate 50% of the capital to purchasing common stock, and the remaining 50% would be allocated to selling put options. This strategy provides multiple benefits to managing risk in my portfolio. First, I am fully invested in the market with the opportunity for capital appreciation and generating dividend income, as well as income from the premium earned from selling the put options. Second, I am also hedging my investment against a downward move, with the put option portion of the trade. In this instance, it is easier to use a real world example to describe how this trade would work. Using AT&T (NYSE:T) as an example, I could buy the stock outright at between $35.80 a share as of the closing price on 6/5/13. I would commit 50% of my desired investment to the common stock, and regardless of what the stock does, I would be capturing an ~5% annualized dividend yield at the current stock and dividend levels. For the other 50% of my desired investment, I would sell the January 2014 $33 put options, collecting $1.36 in premium. This equates to a yield of 4.1% on this portion of my investment over 8 months. Annualized, this would equate to roughly a 6.1% yield. By entering into the agreement to sell the put option as described above, I am effectively committing to buy additional AT&T stock at $33 a share as of January 2014. If the stock is above that price when the options expire in January 2014, I keep the $1.36 in option premium. If the stock is below that price, the 50% of my investment that I used to secure the put options would be used to purchase AT&T stock at $33 a share, regardless of how far below $33 a share the stock might be trading.

This type of approach to investing is rather simplistic in nature, providing the opportunity to commit 100% of the capital you desire to invest in a position while giving up some potential upside in order to hedge against a decline in the market. The table below shows a hypothetical investment in AT&T using the outline provided above, and showing the results after 8 months of a 0% share price decline, a 10% share price increase, and a 10% share decline:

Note that $99,500 was used as the investment amount, allowing for a round number of options to be sold under the 50/50 strategy. Also, the results shown above are using an 8 month time horizon as that is the amount of time prior to the option expiration. This is also why the dividend payment is only 3/4 of an annual AT&T dividend.

You will see that, in a scenario where the share price does not increase or decrease, the outcome from both scenarios is roughly equal, with the 50/50 scenario just slightly yielding a higher return. In the scenario where the share price increases 10%, being fully invested in the common stock as expected yields a higher return. In the scenario where the share price decreases 10%, the loss experienced under the 50/50 scenario is significantly less than if 100% of the capital had been allocated to purchase common stock. I realize that taxes, commissions, and dividend reinvestment opportunities are not accounted for in the analysis above. However from a directional standpoint, the overall outcome of each scenario would see an immaterial impact when accounting for those items.

Does this type of investment strategy have a place in your dividend portfolio? That depends on your risk appetite to some extent. If your completely bullish on the market and your desired investment, then choosing the 50/50 strategy limits your upside. If you're focused on capital preservation, desire to be invested in the market, but have concerns about a correction, this strategy could complement your portfolio allowing for market upside while limiting losses on the downside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.