7 Dividend Stocks With An Income Investment Hedge

by: Todd Johnson
I receive a lot of hedging questions on how to protect a portfolio dominated by dividend paying equities. This article focuses upon a few sample hedging techniques. To avoid any confusion, I am 100% results oriented. I have never been one for excuses.

If our common goal is to make positive net returns, and we don't - then there is a major disconnect between results and expectations. I pay bills by investing. My creditors don't accept "golly, I'm sorry, I had some bad luck" excuses. My investing strategy is 100% results oriented. Stock symbols carry zero relevance to me as they come and go with the passing of the seasons. Those who know Enron, Worldcom, Bre-X know the world I live in. Many promise untold wealth, but few actually deliver. This article is designed to cut to the chase and address the issue of "delivering" results and not providing excuses.

At the end of the month, each investor has to answer two basic questions:

1. How do I hedge my dividend paying stocks? Bear markets can take all equities down, including high-quality dividend stocks.

2. Did I receive an absolute positive return in my dividend paying portfolio? If the answer is "no" over an extended period of time, then the plan is not working according to a strategy. Most investing newsletters, strategies - in the mainstream press - focus only on "long" quality stocks. That doesn't pay the monthly bills if the stock goes down further than the recognized dividends.

If your above answers to the two questions are working for you, then you have found financial solace. If not, you may want to consider basic option strategies as defined in a few basic option books.
It takes extra work on the investor's part, but if investing would be easy then the world would have only millionaires. Let's be honest: we can not predict the future. We have to use common sense and think for ourselves. If we lack such basic investing skills, then we will have to rely upon third parties for our future financial outcome. As Louis Pasteur said, "Fortune favors the prepared mind."

These are only my opinions and suggestions on common dividend paying stocks. Many roads lead to Rome, and this is but one. You may very well have a better strategy. I try to develop a successful strategy, fine tune the strategy, and be consistent in implementing that strategy.

1. SeaDrill Limited (SDRL)
SeaDrill Limited provides offshore drilling services. The company has the latest offshore drilling equipment for the global oil and gas industries. The company chairman of the board is John Fredriksen. Mr. Fredriksen has his diehard investing fans who believe he can do no wrong. He is a billionaire and thus has a modus operandi that may not always be appropriate for difficult investing climates.

I propose we are in a difficult economic environment in which Mr. Fredriksen needs to alter his boom-and-bust methodology of paying out such a significant percentage of earnings as dividends.
click on all charts to enlarge

There comes a time when rainy days appear and cash on the balance sheet can be your best ally. I believe in shorting - or at the very least, hedging - SeaDrill at present prices. The rationale is not based upon SeaDrill's prospects, but their 3rd party contracts. Many companies will suffer in a contracting economic background.

The below hedge would cost cost a net debit $40. This would be your out of pocket expense. The maximum loss is ([$2753 -$2535] = $218-loss) for owning a 100-share SDRL common stock position. The coverage on this trade is through January 20th, 2012.

Here is my proposed 100-share SeaDrill hedging idea. Here are the central option prices:
  • Use the "collar" trade per the playbook.
  • SeaDrill closed at $27.53.
  • I expect SeaDrill to go ex-dividend on approximately December 6th. The amount should be about 75-cents.
  • Sell 1-SDRL Jan 2012 30.000 call (SDRL120121C00030000) for $145.
  • Buy 1-SDRL Jan 2012 25.000 put (SDRL120121P00025000) $185

2. Frontline Ltd. (NYSE:FRO)
Frontline is another John Fredriksen entity. In boom periods, Frontline's ownership and operation of oil tankers is a very lucrative business. In an economic contraction, the daily rates for Frontline's ships are less than desired. Currently Frontline is paying a 2-cents per quarter dividend.

The below hedge would provide a net credit of $15. This would be your out of pocket expense. The maximum loss is ([$487 -$485] = $2-profit) for owning a 100-share FRO common stock position. The coverage on this trade is through February 17th, 2012.

Here is my proposed 100-share Frontline hedging idea. Here are the central option prices:
  • Use the "collar" trade per the playbook.
  • Frontline closed at $4.85.
  • I expect Frontline to go ex-dividend on approximately December 7th. The amount should be about 2-cents.
  • Sell 1-FRO Feb 2012 5.000 call (FRO120218C00005000) $135.
  • Buy 1-FRO Feb 2012 5.000 put (FRO120218P00005000) $120.
3. SandRidge Permian Trust Common (NYSE:PER) and SandRidge Mississippian Trust I (SDT).
I am long SandRidge Permian Trust Common (PER), per this rationale. In addition, I am long SandRidge Mississippian Trust I (SDT), per this rationale. The key risks with these U.S. Royalty Trusts are their exposure to their parent corporation. SandRidge Energy, Inc. (NYSE:SD) is the entity who brought forth PER and SDT to the public markets. I am confident in SandRidge Energy's business model and growth prospects.

I should add that risk preparation must be enacted before an "incorrect" investing assumption is made. If SandRidge Energy's business fails, then SandRidge Permian Trust Common (PER) and SandRidge Mississippian Trust I (SDT) could experience counter-party risk. SandRidge Energy, Inc. (SD) is the operator of both trusts' assets, and a bankruptcy filing could impair my PER and SDT positions.

At the present time, the option alternative SandRidge Permian Trust Common (PER) and SandRidge Mississippian Trust I (SDT) are limited. I recommend shareholders closely track SandRidge Energy, Inc. (SD). There are ample net credit January 2012 collar trade positions if long SandRidge Energy, Inc. (SD). One idea is to be long SandRidge Energy (SD), and employ the following net credit trade to receive income to offset net SDT, PER, SD exposure:
  • Sell-SD Jan 2012 5.000 call (SD120121C00005000) $148
  • Buy-SD Jan 2012 5.000 put (SD120121P00005000) $77
  • This would equate to a net credit of $71-per spread position.
  • This option trade, assuming SD is above $5 on January 20th, would require a repositioning of the short call position on January 20th, 2012.
  • The purpose of this trade is to a) limit downside risk on aggregate SD, PER, SDT holdings, and b) earn income on the net credit premium as time decay becomes our friend.
4. American Capital Agency Corp. (AGNC)
American Capital Agency is well-known among high-dividend-yield investors. The June 30th 10Q book value per share is $26.76. I estimate the Fed's Operation Twist will directly impact American Capital Agency's book value per share, bringing it to $27.24 for the September 30th, 2011 quarter.

The stock currently yields a 20.7% dividend yield. I believe the equity will not trade meaningfully below its book value per share for the September 30th quarter. This value will not be presented until, I expect, October 27th. This is the dividend payment date and also the date of last year's 3rd quarter presentation.

I propose a long put spread for American Capital Agency's 4th quarter. I believe Operation Twist may cause American Capital Agency to have a reduced dividend payout for the 4th quarter, 2011. Dividends for the past 9 quarters have been $1.40-per share. I presume the book value will support the stock price as AGNC is 100% agency-MBS. These are Level 1 GSE-MBS asset valuations.

The trade assumes the 4th quarter dividend will be ex-dividend in the last week of December, as in year's past. Here is the long put strategy:
  • Selll 1-AGNC Dec 2011 26.000 put (AGNC111217P00026000) $90
  • Buy 1-AGNC Dec 2011 20.000 put (AGNC111217P00020000) $15
The net credit spread is $75 put spread contract. The AGNC-common stock price should remain firm as the ex-dividend date will be after the AGNC put expiration date of December 16th.

5. Terra Nitrogen Company, L.P. (TNH)
Terra Nitrogen Company does not offer options. Because of this issue, the investor is really trading on confidence of TNH. I personally have to have a level of confidence. Every investor - as expressed in the "you cannot step twice into the same stream" expression - has unique characteristics: one's portfolio hedges, and one's cost basis or TNH purchase price, and whether one is a short-term or long-term investor in TNH.

Fertilizer producers have remained cautious in the past week. Fertilizer prices are prone to move upward or downward. The investor needs to know the background of the commodity prices to recognize opportunity or disaster. If a security does not offer an option, then a tight stop-limit-order may be appropriate.

6. Philip Morris International, Inc. (NYSE:PM)
Philip Morris International is the bluest of blue chips. Management buys back their stock, management increases their dividend, and management is 100% focused upon investor returns. I have no qualms with such a desired outcome.

Philip Morris International has suffered price-per-share (pps) declines due to one primary reason: the world is sending significant amounts of money to the U.S. Treasury for security due to the euro-currency panic. The U.S. dollar is not designed to provide stability against fiat-currency principles. Those who follow history recognize that a debt-burden currency, will in time, tumble. It's just a fact. Printing money without respect to fiscal balance sheet issues has downside risk.

Here is a simple hedge to reduce Philip Morris International (PM) exposure:
  • Sell 1-PM Mar 2012 62.500 call (PM120317C00062500) $485
  • Buy 1-PM Mar 2012 62.500 put (PM120317P00062500) $525
  • The next cost is $40-debit. This does not include the 77-cent quarterly dividend or the ongoing $5-billion stock buyback plan in effect.

Disclosure: I am long PER, SDT, AGNC, PM.