Investors who want to participate in this market can use options to limit their risk to an adverse move. The S&P/ASX 200 has had a fantastic run in July, rising since it bounced sharply off its June lows. High yield stocks have been moving sharply in the direction of their medium-term underlying trends, as we have seen with the banks and Telstra. Long term investors can look to protect their portfolio positions in this market environment against the risk of a pullback near-term.
Today we investigate the simple Dividend Protection Strategy of buying insurance for your stock position through buying puts. This strategy not only protects your stock position if the price sells off, it also keeps you open to gains on the upside.
If you want to protect your stock position in order to stay eligible for an upcoming dividend, then you can use what is known as a Dividend Protection Strategy. This strategy simply involves buying 1 contract of put options for every 100 shares that you own, at a strike price below the level at which you do not want to own the stock.
CHART 1: The ASX Financials sector has bounced strongly from the June lows.
Commonwealth Bank (CBA)
Dividend yield stocks have seen a strong recovery since being sold off heavily in May-June when overseas fund managers withdrew from the market, following the Aussie dollar’s plummet below parity.
One of the stocks due to pay a dividend in August is Commonwealth Bank. The CommBank stock has bounced 15% from its lows around $64.50 back in June, but is once again trading at all-time highs, refer to the chart below.
CHART 2: CBA weekly chart
CBA Dividend Protection
After such a strong bounce from the June lows and given that the company is due to report on the 14th of August 2013, we thought it timely to protect our CBA position from a significant fall, while still holding the stock to be able to collect the dividend of around $2.00, due to go ex-div mid-August.
With the stock trading at all-time highs around $74.60 you could purchase a protective put, the CBA 7300 SEP13 PUT at $2.00/contract. If you bought the stock at $67.00 in the last month, your position would be protected until the September expiry down to $71.00 (= $73.00 – $2.00) thereby locking in profits on your position, while still allowing you to qualify for the upcoming dividend of $2.00 plus franking credits.
Payoff Diagram at September Expiry
CHART 3: Payoff Diagram at Expiry for the Protective CBA 7300 SEP13 PUT combined with stock purchased for $67.00.
The upper breakeven level for the Put option trade at expiry would be $75.00. The maximum risk on the option is the initial $2.00 debit/contract which would occur if CBA stays above the Put Strike $73.00 at the Put option expiry.
Note: if your view changes during the trade, you can sell the put or close the trade prior to expiry.
Trade Risks and Profit Potential
This Dividend Protection Strategy of buying insurance for your stock position through buying puts, limits your down side on the stock position while still allowing you to benefit from further gains in the stocks and also qualifying for the upcoming dividend. The risk/rewards are shown in the Payoff diagram above.
Note that as with any long option position, time decay eats away at the option value, and this time decay accelerates in the last six weeks of the option’s life.
This trade is still in progress, but CBA sold off heavily yesterday (down to near $72.00) and the put option could have been sold for $3.30/contract (a 65% profit).
Options volatility has been contracting in the past few weeks and this has given investors the opportunity to benefit by buying options. The value of the option stands to increase if the stock moves in your expected direction or if volatility increases.
Options can be used in order to protect your portfolio positions, while still participating in potential shareholder benefits, such as dividends.
Investors can protect their portfolio for a fraction of the cost of simply buying puts outright. If you would like more information please contact me at call 1300 610 024 or email firstname.lastname@example.org.
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Investment Adviser – D2MX Trading
Also In This Series
Part 1: The Protective Put
Part 2: The Covered Call
Part 3: The Covered Call Collar
Part 4: The Stock Repair Strategy
Part 5: Limited Risk Short Selling Strategy
Part 7: Dividend Capture Covered Call Collar
Part 8: Hedging With a Bear Put Spread
Part 9: The Bull Call Strategy
Part 10: Dividend Capture Covered Call Collar
Part 11: Calendar Call Strategy
Part 12: Bull Call Spread Strategy
Part 13: Reverse Calendar Call Strategy
Part 14: Short Selling Strategy with a Hedge
Part 15: Alternate Profit Taking Strategy
Part 16: Bullish on the Cheap
Part 17: Trade Smarter with Options
Part 18: Trade The Switch with Options
Part 19: Managing The Protected Capped Covered Call Collar Trade
Part 20: The Synthetic Long Stock Strategy
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.