Can options replace the need for diversification?

We have all been cautioned since the first time we thought about investing, that we must diversify. You cannot invest in any one issue or even market, because the risks are too high.

Are they really?

What if your investment strategy is to seek 4% dividend yield? Would it be all right to put all of your capital into stocks yielding 4% or more? Many will say no, that this by itself does not diversify your portfolio. I disagree.

There are hundreds of stocks yielding over 4%, which is indisputable. The problem arises when market risk is brought into the picture. This is where you need diversification, including picking up shares of some companies that yield low dividends, or no dividends. Here again, I disagree.

Imagine a strategy not based on capital gains and buy-and-hold strategies of value investments. If you would be happy with annual yields of 4% or more, you can accomplish that by buying shares of only those companies yielding in this range. Consider, for example, Altria (MO), AT&T (T), Verizon (VZ) Eli Lilly (LLY), Avon (AVP), ConocoPhillips (COP), Credit Suisse (CS), or Lockheed Martin (LMT) – a small sample of about 750 companies yielding above 4%.

But what about market risk?

If your intention is to focus on 4% or more annual income, focus on dividends and hold stock in a risk-free environment. Use collars to prevent losses on the downside, while being willing to accept exercise if prices move above the short call’s strike. If that happens, pick one of the other 740 stocks and continue with the plan.

One example among many: Altria (MO) closed on June 19 at $33.92 per share. A collar based on August consisted of the 34 call at 0.69 and the 33 put at 0.42, a credit of 0.27 before transaction fees. Or the September contracts revealed the call at 0.84 and the put at 0.76, or 0.08 debit before transaction costs.

It’s a strategy worth thinking about, especially if you have been relying on guesswork and timing to make money on stock positions or to speculate on options. Use those options to reduce risk while protecting basis, all to create a nice 4% or more return every year.

With that working for you, who needs diversification?

Michael C. Thomsett

About this week’s Heavy Hitter: Michael C. Thomsett is a widely published options author, with six options books in print, published by John Wiley & Sons, FT Press, Amacom Books, and Traders Library. Thomsett blogs at FT Press, Benzinga & Seeking Alpha, his websites are www.MichaelThomsett.com and www.ThomsettPublishing.com

 Twitter: @ThomsettPublish