Is it possible with well-selected and timed options positions, to combine high-yield and low-risk? Yes, but it takes work to locate the right proximity and value.
The dividend collar is so-called because timing involves ex-dividend date. The idea is to move into a long stock position right before ex-dividend date, protect that position with options, and then exercise out right after.
The collar consists of 100 shares long, a long put, and a short call. The ideal proximity is that both strikes are slightly higher than current value, but it is difficult to get the price offset with that ideal. You are more likely to open a dividend collar with both options slightly in or slightly out of the money. Strangely enough, it doesn’t matter which you choose. The main requirement is that the net cost of the long put is offset by the premium from the short call. A second requirement is that upon exercise of either option (the short call by the buyer, and the long put by you), it ends up at zero loss or even a small profit.
With these restrictions in mind, the most likely underlyings are going to have one-point strike increments. For example, Verizon (VZ) fits the bill perfectly. Not by way of recommendation, but only for the sake of example, VZ closed on March 23, 2012 at $39.42. Ex-date occurs on the Jan-Apr-Jul-Oct cycle. So the April 21, 2012 expiration is the target for a dividend collar. Ex-date occurs right before expiration, an ideal setting. The April 39 call was at 0.65 and the April 39 put was at 0.58. The net credit is $7 (selling the call, buying the put). After transaction costs (figuring in a ticket charge to your broker plus a per contract charge, your commissions may differ) you might be at a debit of about $11, attractively close. The dividend is 50 cents per quarter, or $50. So if you subtract the $11 debit from the $50 dividend, the net outcome is going to be about $39. If you use 300 shares and three sets of options instead of 100 shares and single options the cost per drops sharply. Only do a quantity you are comfortable with.
Exercise of the call can be avoided by closing the position or rolling forward; or exercise can be accepted, advisable if the original basis is lower. However, if the basis is at or above $39, the strategy won’t work. The long put provides downside protection in the form of an insurance put. This strategy is going to work best when the basis is lower than the strikes; for example, if you bought Verizon at $35 or $36, exercise of either option produces a net capital gain.
The key to the strategy is rolling in and out of long stock every month based on quarterly cycles, thus being stockholder of record for only a few days and earnings dividends every month instead of every quarter. For example, if you set up dividend collars every month on underlyings yielding 4%, the outcome is a 12% dividend yield for the entire year. Verizon’s dividend at this point was 5.07%.
The “if” factor requires a few components to make this strategy work well:
1. Basis in the underlying below the strikes.
2. Offset long put and short call as close to zero as possible.
3. Ex-dividend date immediately before options expiration dates.
4. Dividend yield at an attractive level (for example, 4% or higher).
The beauty of this strategy is that it does not matter how rich option premium is, as long as the long and short are offset. Impending expiration is not a disadvantage either, because the purpose to this strategy is to earn the dividend, not to profit from options or stock.
One potential glitch: If the short call is in the money on ex-dividend date, you may be assigned (how much in-the-money, how close to expiration may determine if the in-the-money call is exercised by the holder of the option). There are other folks out there who would like to get the dividend, especially at over 4% or 5%. So the strike has to be set up so that an exercised call is profitable as an alternative to earning the dividend.
So do your homework, look for stocks that qualify for this, but do not ignore the commissions involved.
Michael C. Thomsett