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The Dividend Collar, A Hedge For Some Conditions

|Includes: BMY, LLY, Verizon Communications (VZ)

Many high-quality stocks are paying large quarterly dividends these days. A strategy based on earnings dividends would be worthwhile, if only the market risk could be eliminated at the same time.
Dividends are paid quarterly to stockholders of record prior to ex-dividend date. If you were to buy 100 shares of stock in time to qualify for the dividend, with the idea of selling shares soon after, you could triple the annual income. For example, a company paying 4% is going to shell out 1% per quarter. If you buy shares, wait for ex-dividend, and then sell, that 1% in less than a month works out to 12% per year. Of course, this means you also need to find three companies yielding annual dividend of 4% or more, and go in and out every month to get the larger dividend income.
Here is an example: Below are three companies paying varying levels of dividend per year:

Verizon (NYSE:VZ) 4.1% dividend, ex-dates Jan-Apr-Jul-Oct
Eli Lilly (NYSE:LLY) 3.7% dividend, ex-dates Feb-May-Aug-Nov
Bristol-Myers Squibb (NYSE:BMY) 3.0% dividend, ex-dates Jan-Apr-Jul-Oct

Using the timing strategy, you can buy shares for each of these corporations before ex-date and then sell before the following month's ex-date. This creates annualized dividend yield on all three companies well in excess of the yield based on quarterly payments - because you can repeat this every month and get monthly payments instead of quarterly payments.
The big problem with this strategy is market risk. What happens if the share price falls before you have a chance to sell?
This is where the no-risk, no-cost options strategy comes into the picture. By opening a collar, you avoid downside risk completely. A collar has three parts: 100 shares of stock, a short call, and a long put. If the covered call and long put are both opened at the same strike and at or close to the money, you have several advantages:

1. The cost of the long put is offset by the income you get for the short call.

2. If the stock price rises, the stock is called away at breakeven or a small profit.

3, If the stock price declines, the long put will be in the money. You can exercise the put and sell 100 shares at the strike.

Based on price per share on June 9, 2013 for each of these companies, the following values were found:

Company Ex-Date Price Call premium Put premium Net cost or credit (-)
VZ July 50.24 Jul 50 1.26 Jul 50 1.45 -0.19
LLY August 52.09 Aug 52.50 2.23 Aug 52.50 2.56 -0.33
BMY July 47.50 Jul 47 1.68 Jul 47 1.50 0.18

The net cost or credit is calculated based on selling the call and buying the put.

The dividend-focused collar requires only that you open a long put and a short call at the same strike. Opening these at the next expiration maximizes income because you will get out of the stock quickly, freeing up capital for next month's ex-dividend on another stock. How do you get out? If the call goes in the money, your 100 shares will be called away. If the long put goes in the money, you exercise and sell your shares at the put's strike. Because the strategy is based on profits generated by dividend income, the cost/premium of the options does not really matter at all as long as it is minimal.

The dividend income, no-risk, no-cost strategy is elegant because it combines the best of all worlds. You can generate dividend income without worrying about what happens to the value of your stock. You only want to own it long enough to get the quarterly dividend.

I have written a book on the subject of the dividend collar, and it has been published by Palgrave-MacMillan. The book can be ordered at the link: Options for Risk-Free Portfolios

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