Using Options And High-Yield mREITs To Get A Risk-Neutral 4-6% Return

Includes: AGNC, CYS, HTS, IVR, NLY
by: Mateo Blumer

Considering the current market conditions, wouldn't it be nice to have a stable investment yielding 3-4% annually? You could just buy some TLT or AGG, but given the recent rally in bonds, it's likely that within the next 12 months interest rates will climb back up from their lows and send bond prices back down, causing capital losses far greater than the 3-4% yield for those holding such ETFs. So, here in another in a series on options strategies, we will be looking at using a combination of call options, put options and high-yield mortgage real estate investment trust (mREITS) stocks in order to create a risk-neutral strategy for which we know in advance the maximum possible loss. (See bottom of this article for a detailed description of the risks involved. "Risk-neutral" refers to stock price risk only).

In a nutshell, we are going to be investing in high-dividend mREITs while using stock options to hedge out some of the price risk. The aim is to create a scenario where the expected loss from the strategy (before dividends) is less than the total dividend expected to be received during the time between option purchase and option expiration. I say "expected loss" because, without the dividend, the following strategy I'm proposing would usually not be profitable. That being said, I consider the risk of these companies halting their dividends during the next 6 months to be quite low - about equal to the chance that we will enter another full-fledged 2008-style recession between now and then. Even if it happens, the loss from our strategy will be capped, and typically won't exceed 10%. On to the moneymakers, the following mREIT stocks are ideal for this strategy because of their giant dividends:

Name Ticker Dividend Yield
American Capital Agency Corp AGNC 20.17%
Annaly Capital Management NLY 14.71%
CYS Investments Inc CYS 17.31%
Hatteras Financial Corp. HTS 15.36%
Invesco Mortgage Capital Inc IVR 24.43%

We could have added Chimera Investment Corp. (NYSE:CIM) and Two Harbors Investment Corp. (NYSE:TWO) to this list with their 18% dividends, but I would advise against attempting this strategy using stocks with a share price below $10. I will use Invesco Mortgage Capital Inc (NYSE:IVR) for this example.

So here's the deal: we want to be able to capitalize upon IVR's excellent dividend, but don't want all the price risk that comes with investing in these companies in a traditional long-only manner (IVR shares are down to $15.32 from $21.84 YTD for example, representing a 29.7% decline). Obviously we have to hold the stock in order to collect the dividend, but we can buy protection against share price decline using put options, creating a scenario where we now know our maximum loss resultant from changes in the stock's price. From there, to offset the cost of the put option, we can write a covered call, generating a little income and effectively setting a maximum return (excluding dividends) on our possible return from the strategy.

Like all options-based strategies, there is a lot of room for customization here in terms of option expiration and strike price. We will be focusing on options with durations that capture 2 dividend payments - usually two quarters, or 6 months. That means today, for IVR, we would be buying and selling the April 2012 options (currently the furthest-away expiration for IVR options). We are going to use the same expiration for the put we buy ("long put") and for the call we sell ("short call"). IVR looks scheduled to pay a quarterly dividend in December, and then again in March. The last dividend payment in September was for $0.80 per share, so for the sake of simplicity we will assume it to be the same in December and March. IVR was trading at $15.38 on Friday.

For the strike price of both the long put and the short call, we are going to stay close to the money ($15-16). From this point forward, there are essentially two sub-strategies here - although each still has a maximum loss and maximum gain. The point of differentiation between the two is whether or not the strike price of the two options is equal; in our case, they will be. So, if we buy 100 shares of IVR today, sell a $15 April 2012 IVR call and buy the $15 April 2012 put - so the put and the call have the same strike - we are entering into a strategy known as "conversion arbitrage." This is a risk-neutral strategy, meaning that regardless of where IVR's price ends up, our profit/loss (excluding dividends) from the strategy remains the same. If the strike prices of the short call and long put are not equal, the strategy is no longer risk-neutral. This doesn't mean, however, that the strategy only works if the strike prices are the same; it just means there is more variability in the outcome if the strike prices are different. Typically, that means that if the strike price of the call is greater than the strike price of the put, the maximum profit is achieved when the stock rises; conversely, if the strike price of the call is below the strike price of the put, the maximum profit is achieved when the stock goes down. In this example, we will be utilizing our own version of conversion arbitrage - high-dividend conversion arbitrage - to capitalize upon IVR's high dividend while neutralizing the risk of stock price movement.

Excluding dividends, conversion arbitrage it is typically only profitable when the call option is overpriced relative to the put option. For us, we will make money if the total dividends we expect to receive between now and April 2012 on 100 shares of IVR exceeds the P/L from the strategy (before dividends). Outside of this particular example, the rules are the same: the strategy will be profitable if the value of the expected dividends to be received between now and the options' expiration exceeds the P/L from the strategy (before dividends).

Let's look at how this works: For example, using Friday's prices, let's say we buy $100 shares of IVR at $15.38, sell a $15 April 2012 call for $0.90 and buy the $15 April 2012 put for $1.59:

High-Dividend Conversion Arbitrage P/L at Expiration
Stock Price Stock P/L Call P/L Put P/L Total Non-Dividend P/L Dividend Total P/L Return
12 ($338) $90 $141 ($107) $160 $53 3.29%
13 ($238) $90 $41 ($107) $160 $53 3.29%
14 ($138) $90 ($59) ($107) $160 $53 3.29%
15 ($38) $90 ($159) ($107) $160 $53 3.29%
16 $62 ($10) ($159) ($107) $160 $53 3.29%
17 $162 ($110) ($159) ($107) $160 $53 3.29%
18 $262 ($210) ($159) ($107) $160 $53 3.29%

As you can see, before dividends, this strategy will have a loss of $107. On our total investment of $1,607 ($1,538 + $159 - $90), that is a 6.6% loss. This is the maximum possible loss, and would be the return from the strategy in the event that the company completely stops paying its dividends. Barring that unlikely scenario, in our example we will be collecting a substantial dividend: ($0.80 x 100) for December and ($0.80 x100) for March, meaning $160 total between now and April 2012, when our options expire. Thus, our total P/L for this strategy - assuming the dividend remains consistent - will be $53, which is a 3.3% gain in 6 months. Do this twice a year, and that's over 6% annually.

However, the rate of return from the strategy won't always be the same, as there are several changing factors in play - such as the different expiration options available at different times, varied option premiums due to changes in volatility, etc. Sometimes no options are available with expirations that are at least 6 months away; in that case, you could enter into the strategy with shorter-expiration options, and then "roll it over" (replace the options with longer-term ones right before expiration), but that we will cover in another article. To find the best way to implement the strategy, you should shop around, and examine the expected returns using several different mREIT stocks. Perhaps by the time April rolls around and our strategy expires, HTS may be a better stock for this strategy than IVR.

Evaluation of Risks Involved

Although the above strategy I describe allows you to create a scenario where you have both a maximum loss and maximum gain (exclusive of dividends), it is by no means truly risk-free. At any time, if it becomes evident that a publicly traded company is engaging in fraud or shady accounting practices, or if a company fails to comply with one of the thousands of exchange requirements, there is a good chance the stock will be de-listed from the exchange it trades on. This happened to me back in March, when, after reading a report from Muddy Waters Research proclaiming fraud at the Chinese company China MediaExpress Holdings (OTCPK:CCME), I entered into a bearish put spread attempting to profit from the stock's decline. The stock proceeded to plummet as expected, but by the end of April, trading in CCME was halted and the stock was soon delisted from NASDAQ. Strangely, the value of my put options went to 0; it appeared that I lost money on the puts I bought, and made money on the puts I sold. Even worse, I was unable to close out of my positions, and had no choice but to just sit and wait to see what happened. Two days before my options' expiration, my positions were automatically closed out by my brokerage. Luckily, I was reimbursed for my now-worthless put options, but my capital was tied up for over a month in a position that I should have been able to close out of at any time. Thus, the following strategy may eliminate risk pertaining to stock price movement, but it doesn't eliminate broader risks such as the possibility of the stock being delisted. The stocks I propose for use in this strategy are certainly less shady than CCME, but fraud and illegal practices can happen within even the best-run organizations.

Another risk is the possibility that the company will cut or cease to pay its dividends. Although this is far less problematic than having the stock delisted, the profitability of the following strategy relies on the high dividends that these stocks pay. If you enter into the strategy and the dividends stop, you still have a maximum loss and maximum gain, but you probably won't post a profit. It is actually quite likely that the dividend amount and yield for all of these mREIT stocks will change a little, whether it be rising or falling; again, the conversion arbitrage strategy neutralizes risk from changes in stock price, but can't do anything to neutralize the risk of dividend yield/amount changes.

Also, trading options on these stocks can be difficult, as sometimes the volume is quite low. I would suggest using limit orders instead of market orders, especially when the bid-ask spread is wider than $0.05. Once you have purchased or sold an option, it may thus be difficult to close out of it at a favorable price; for this strategy, it is good to anticipate that you will be holding on to the long and short options positions until they expire.

Disclosure: I currently own CYS stock (long) and hold CYS put options.