In his article, "Dividend Aristocrats in Focus Part 3: HCP", Ben Reynolds points us to the curious case of HCP Inc. (HCP, Financial), a REIT that specializes in health care-related properties.
As you may know, the Dividend Aristocrats list refers to a group of stocks that are listed on the S&P 500, have increased dividends for at least 25 consecutive years, and meet other criteria (see the October 2016 list of companies here). Making it onto this list—and staying on it—is a very significant accomplishment for any company. Only 50 have that honor at the moment, and being on the list gives a stock credibility with investors.
But confidence would not be the first word that comes to mind if you glanced at HCP’s financial strength and profitability & growth ratings at GuruFocus:
A dismal sight. What’s more, as this price chart shows, investors have bid down the price of the company from the mid-$50s to the mid-$30s:
Despite all this, though, the company has kept increasing its dividend year after year. Reynolds notes it is now the highest yielding stock among all Dividend Artistocrats, at 6.4%.
In this article, we look at using an options collar to backstop an income investment, to collect those healthy dividends while minimizing our risks. For more on those company risks, see this article and Reynolds’ article noted above.
Why options protection?
We could review the articles and the fundamentals, and say Yea or Nay to the stock and just buy or not buy. But going in with an option collar allows us to take most of the risk out of investment—in advance.
It starts with a protective put (or married put if bought at the same time as the stock) which provides a floor price. Normally we think of an option put as similar to car or homeowners’ insurance, and that’s the case here.
Many investors turn their backs on protective puts because of the cost; they would have to pay a premium to protect the stock. We will use an option collar, though, which adds an income component to reduce or fully pay for the protection.
So, our theoretical position involves:
- a stock that’s been on shaky legs for a couple of years (although continuing to increase its dividend);
- a protective or married put that insures most of the capital we put into the stock, and;
- option calls, which generate income to pay for some or all of the cost of the puts.
Let’s look at specifics by creating a table that shows one (of many) configuration based on prices at the close of trading on Monday, Oct. 17:
Creating this collar for HCP will result in a maximum exposure of $315 or 7.6% of the cost of the stock and protective/married put. In other words, the worst case scenario is a loss of $315. Note that it does not cover the possibility of the dividend being cut (although a cut would undoubtedly push the share price lower).
If the share price falls below $33.17 ($36.32 - $3.15) you have 100% insurance coverage; you will get back, dollar for dollar, any price reduction below $33.17. Between $33.17 and the current price, you will get back some portion of your loss when you sell or exercise the put.
Comments: Options protection allows us to quantify, and often minimize, the amount we might lose when we buy a risky income stock.
Variations on a theme
Stock options offer great flexibility; you can
- Sell a call
- Buy a call
- Sell a put
- Buy a put
And even within that universe, different strikes (option exercise amounts) and different expiry dates exist.
For example, rather than selling a call that expires in January 2018, fifteen months from now, you could sell options on a monthly basis. Generally, that will mean more work, but also more income. Here’s an excerpt from the HCP options chain (table) for Nov. 18, 2016, one month away:
Looking down the Bid column to the $37.50 row, we see a price of 55 cents, which means we would receive a premium of $55 per contract for one month. Multiply that by 14 months and we have a total of $770. That’s $300 per contract more than the cost of the put options, but it would mean extra work every month, a proposition that becomes more attractive if you have higher numbers of shares. For example, if you own 1,000 shares that would mean 10 contracts and $3,000 (10 x $300).
Now we need to accept that the premiums from selling calls will vary from month to month, but this gives us a rough idea of what is possible. We can even check out the volatility chart at iVolatility to find out how normal the current volatility is (volatility is a major contributor to option prices):
This 1-year chart shows us that the current volatility is fairly normal, and in turn, that the premium is relatively normal. Be careful during months when the company is reporting earnings; many investors who sell calls skip earnings months because of the uncertainty and less predictable volatility.
Comments: Many variations are available, including some that allow us to take in income greater than the amount we spend for the protective/married puts.
Changing positions as you go
Having set up a position like this doesn’t mean you must, or even should, stick to it. Share prices go up and down, presenting opportunities to improve our overall position or make extra income.
For example, if the price of HCP drops significantly, then we can sell the protective/married puts we own at a profit, and buy new puts at a lower strike price. We sell the original puts for more than we paid, and keep our insurance in place by buying new puts. While the profit on the original puts likely won’t cover the full capital loss, you will be in an even better position when the share price goes up again (a reasonable assumption in most cases).
At the same time, a significant drop in the share price also means you can buy back the call options you sold, and buy them back at a highly discounted price. Thus, having cleared the deck, you can sell calls again, also at a lower strike price. Between buying back the old calls at a discounted price and selling the new calls, chances are good you will bring in some profits.
On the other hand, if the share price goes up after you establish your collar, you need to sell your puts and buy back your calls before expiry. This will be trickier, but by rolling up your calls and puts, your overall position could improve.
Of course, if you think the share price will go up soon after you buy, then you would not sell covered calls against the stock. Instead, you would wait until you think the share price has plateaued. Alan Ellman of the Blue Collar Investor has an interesting and helpful example of making adjustments when the share price moves sharply upward; see it here.
Comments: Active investors get more out of their options collar by making adjustments when the share of the underlying stock move up or down.
Caution
Stock options work in mysterious ways, we might say, jumping this way or that with no immediately discernable reason. If you have not used options before, take some courses and paper-trade extensively before committing real money.
They also require regular monitoring, much more attention than required for a pure stock holding. Paper-trading will help you get a sense of how much time you, personally, will need to devote to them.
Conclusion
The purpose of this article was to explore how we might reach for a high-yield dividend without taking much risk.
HCP Inc., a company with some shaky fundamentals, pays a dividend of more than 6%, which will be attractive to some income investors.
By transferring away some the risk, through protective/married puts, income investors can go for the dividend and still sleep at night.
At the same time, selling covered calls on HCP allows those same investors to recoup at least a portion of the costs they incur, and potentially open up new streams of income.
The biggest price investors pay for both halves of the options collar, the puts and the calls, is time and effort. The many options tools available make options positions relatively simple and inexpensive, but the need for at least some commitment remains.
Disclosure: I do not own shares or options of the companies listed in this article, nor do I expect to buy any in the foreseeable future.
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