Limiting The Downside Risk In A Dividend Stock Portfolio

by: Efficient Alpha

By Emil Emilov

In general dividend stocks are bought with a long term perspective and many people who own them are not particularly interested in the short-term price movement of the investment. The idea behind such thinking is that eventually, given the company is strong enough, the market will notice that strength and the price will reflect it. In the meantime the investor is collecting the dividends and securing a fairly steady income.

But what if one is not so inclined to hold a stock indefinitely or would like to exercise a more active approach concerning the downside risk of his or her investment? Limiting the magnitude of the downside risk could be done through various types of hedging. Some of the available methods are investing in different asset classes, indices, or currencies that move opposite to your holdings in price.

Another way is to take advantage of options available on your dividend stocks. One may buy put options or sell call options, as explained in a previous article on how to protect portfolios in volatile markets. A problem that usually arises with using options as hedging strategies is that the hedge expires with the option expiration. The hedge works for a finite time, but the investor must pay additional premiums periodically. If the investor is about to hold the dividend stock indefinitely there is no way to tell in advance for how long the hedge should last in order to minimize any additional costs which could incur.

A way to escape this time limitation is to find an asset, or group of assets, that would move in price inversely to your holdings and which do not expire in time. A typical example of such a hedge against a decline in equity holdings in turbulent times would be buying gold or until recently, the Swiss franc (CHF). Exposure to gold can be accomplished through the SPDR Gold Trust Holdings (GLD) which invests in physical gold bullion and is designed to track the spot price of gold bullion. The Swiss franc was acting successfully like a hedge during the current financial crisis until the Swiss National Bank decided to effectively put a ceiling on the CHF growth against the euro a couple of weeks ago. The SNB decision shows that the assets used for hedging should be continuously monitored to see if they still perform as such.

Let's say you've found an asset that moves almost perfectly contrary to the dividend stocks you hold. Investment may limit the downside potential of your total investment, eventually keeping the change of total investment at or around zero because opposite movements in price would offset each other. While price return is limited, you will still be collecting the dividend on you stocks. This strategy may require a large capital investment. Hedging your entire portfolio in such a way could mean a lot of additional money invested. Some form of leverage (or margin) would in general reduce the money needed for the hedge but the leverage does not come without risk as well.

Another method to hedge the downside risk of your dividend stocks portfolio while still having the opportunity to take part in any increase of their value is to buy put options on the stocks in the portfolio. The idea is that the put options would stabilize a value below which your portfolio would not go for the time till the options expire. That would effectively put a floor on the portfolio while the dividends keep flowing in. Granted, this would only be a strategy you would want to use in the short-term to protect against expected declines in asset prices because the premiums paid for the put options will drastically eat into dividend returns.

Another caveat in hedging the downside risk with put options comes from the tax implications such an action might have. Limiting the downside risk of the dividend stocks by buying put options on them might lead to the dividends received during the period of the hedge not being qualified and thus have a higher tax rate than if qualified. This is because in general the period of the hedge is excluded from the minimum 61 days needed to qualify the dividend. Still such a hedge could be suitable in situations when a protection is needed outside the holding period of 121 days that surround the ex-dividend date. For more info on this matter one should contact a tax adviser.

Below is a practical example of how put options could limit a downside risk of a portfolio and how would they effect the portfolio's dividend yield and return. By using Google stock screener I found 10 stocks which have a dividend yield of at least 5% and a positive P/E below 10. Other criteria included market capitalization of at least 1B, positive operating and net margin, positive current ratio, average daily volume.

The companies presented by the screener are AstraZeneca plc (AZN), Eli Lilly & Co. (LLY), Eni S.p.A. (E), Royal Dutch Shell plc (NYSE:RDS.A), SK Telecom Co., Ltd. (SKM), STMicroelectronics N.V. (STM), Statoil ASA (STO), Telefonica S.A. (TEF), AT&T Inc. (T), and TOTAL S.A. (TOT). To add a broad market comparison, I’ve added the SPDR S&P500 ETF. The annualized return is based on five years of monthly data.

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Table 1; Annualized return is based on 5 years of monthly returns data

From that list of companies I've constructed several portfolios consisting of five companies with different annualized returns and different values of risk measured by portfolio's volatility.

Table 2; Annualized return is based on 5 years of monthly returns data

The criteria for choosing particular combinations vary but might include highest dividend yield (A), highest return (C, D) or lowest annualized volatility (B) among others.

Some of the practical problems in hedging are now beginning to appear. The first problem is selecting the time horizon for the options. In general the longer the hedge, the better as it does not limit the upside potential of the stocks prices. But in practice there are some things to consider. One of those is the tax implications which were mentioned earlier. Sometimes shorter hedging periods could prove to be more suitable if they don't increase the tax rate. That however, comes at the expense of less restrictive hedging than if the period was longer. The reason is that one pays disproportionally higher premiums for options with shorter expiration times given the time difference in hedging periods.

Next we should decide on the particular strikes of the options. That would depend on the current market price we are aiming to hedge, the available put options and our expectations on the possible decrease in the particular stock price for the period of the hedge. The options could be out-of-the-money or in-the-money. In order to minimize the possible unprotected negative return we should select put options which create the smallest increase in the breakeven price. For example, for the SKM which traded at $14.44 at the time of writing, we have the in-the-money $15 strike Mar, 2012 put option and the out-of-the-money $12.50 strike Mar, 2012. We could get the in-the-money option as it creates a smaller burden compared to the next higher strike ($15 - $14.44 + $1.85 = $2.41, $14.44 – $12.50 + $0.72 = $2.66, $2.41 < $2.66).

This of course, should be combined with investor’s expectations on the movement of the stock price itself. In the case of SKM the in-the-money put premium as a percentage of the stock's current price goes to 12.80% so to buy such a hedge the investor should have expectations for a significant downturn. In general if you don’t expect a down movement during the hedging period to exceed the percentage of the stock price you pay as a put premium, such a hedge would not be reasonable. It depends mostly on investor’s risk attitude. If the investor is completely risk averse he or she might prefer to pay an extra premium to eliminate the downside risk completely while hoping for a bigger increase in the stock price.

Let’s assume we have decided to play it extra safe and hedge every stock in the portfolio. That could be the case if the investor expects a significant downward movement of the market in the hedging period. We could now calculate the maximum possible negative return over the time frame of the hedge. In general that would be the same as to find the difference between the breakeven prices and the strike prices. The result is shown in the table below.

Table 3

In both cases – hedged with one month or half year options available at the market, portfolio D seems to be the one that can experience the least unprotected downside movement during the hedge period. Portfolio A which consists of stocks with highest dividend yields might experience the biggest negative return given the options used for protection.

So basically by hedging with put options an investor could effectively set a floor on the portfolio's value. The maximum value of possible loss for a specified time would be known and portfolio's volatility on the downside reduced. At the same time the investor would be able to profit if the stocks prices appreciate and will continue to reap dividends.

The above is just a general example of the idea of hedging dividend stocks with options. It could be suitable for periods when investors expect a major downturn in prices. One should not forget to pay attention whether the hedging would result in higher tax rate on the dividends according to current tax laws.

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