Nested Interest

With interest rates pretty much at zero, conservative income investors have found themselves facing a predicament: take a big income pay cut or take on more investment risk.  Judging from the inflows into dividend stocks and equity income funds, it appears that many have chosen the path of assuming more investment risk.  Dividend income strategies are riskier than laddered bond strategies or an immediate annuity, as corporations are under no contractual obligation to maintain their dividend, which can be reduced, or eliminated, at any time.

I am a strong believer that dividend income should not be a sole, or even primary, source of retirement income for most investors because of this risk; however, with so many pursuing such a strategy it is my hope that investors will at least consider doing this in a way that can dramatically reduce their downside risk, by using what is called a “collar.”

How a Collar Reduces Downside Risk

A collar reduces your risk by creating a floor on the selling price of the stock that you are holding.  By creating a floor, you reduce the amount of potential loss that you are exposed to if the value of the stock were to decline below a specified level (worst case scenario would be a 100% loss).  It would not be unusual for a stock that experiences a significant drop in price to also reduce its dividend, so protecting against a drop in share price can also provide some protection against lower future dividend income.  In fact, one comment I often hear from dividend income investors is that if the dividend is reduced, no problem, they’ll just sell the stock and buy one with a higher dividend.  The problem with this “strategy” is that a reduced dividend typically results in a lower share price, thereby lowering the purchasing power of your investment principle.  The downside protection offered by a collar can better protect you against this risk if this is, in fact, your contingency plan.

What Does a Collar Cost?

If created in the right way, it is possible to create a collar without having to pay any out of pocket costs.  This is accomplished by “selling off” some of the potential upside return on your stock to another investor.  In effect, the cash that you get from selling off the rights to future positive returns is used to pay the cost for the downside protection.  For those who are more focused on the income generating properties of their stock portfolio, this may be a welcomed tradeoff – forgoing some of the growth potential on the stock for downside protection.

While a collar can be constructed with zero out of pocket cost, there is still a cost – the cost of giving up some or all of the future upside potential on your stock.  It is not a free lunch.

How Do You Build a Collar?

Collars are built by combining long positions on put options tied to your stock (which provide the downside protection) and short positions on call options tied to your stock (the selling off of the potential future growth to another investor).  An “option” is a security that grants its owner the right to either buy (i.e. a “call option”) or sell (i.e. a “put option”) a particular security (i.e. your stock) at a given price, within a given time period.  Options can be bought and sold through a brokerage account (although you most brokerages require that you receive special approval to engage in options trading).

So, to build a collar on dividend stock, we would purchase put options (i.e. “long position”) and sell call options (i.e. “short position”).  Purchasing the put option gives you the right to sell the stock at a specified price; if the price of the stock were to drop below this specified price, the put option becomes quite valuable (as you have locked-in a selling price above the lower market price).  Selling the call option gives the buyer of the call option the right to any appreciation in share price above a specified price; if the price of the stock were to increase above this specified price, you will then need to pass along any gain associated with the excess of market price over the specified price to the owner of the call option.

So, just to summarize the impact of a collar on the risk profile of a dividend stock, here is what the gain/loss profile of the dividend stock would look like before entering into a collar:

…and here is what it looks like after the collar:

Point A in the chart above corresponds to the “strike price” of the put option; when the share price of the stock drops below this amount, the put option begins to pay off (paying $1 for each dollar the share price is below the strike price).  When the share price is below the put option strike price, each dollar of gain on the put option offsets a corresponding dollar of loss on the stock, resulting in a level gain/loss at any price below the strike price.  Point B in the chart corresponds to the strike price of the call option; when the share price exceeds this amount, the short call position requires you to pay $1 for each dollar the share price exceeds the strike price.  When the share price is above the call option strike price, each dollar of gain on the stock is offset by a corresponding dollar of loss on the stock, resulting in a level gain/loss at any price above the strike price.

Here is an example to illustrate how a collar can protect a dividend stock investment.

An Example:  AT&T

Let’s take a look at AT&T, which at the writing of this blog was trading at $33.82 with a 12 month expected dividend of $1.80 (a 5.32% yield).

Let’s suppose we are focused on a 14 month time horizon.  Here is what the gain/loss on a share of AT&T would look like at different AT&T share prices at the end of the 14 month period:

The line representing the gain/loss has a slope of one, meaning that for each $1 change in share price, there is a corresponding $1 change in gain or loss.  The line crosses the X axis at $33.82, equal to the current share price, meaning there would be zero gain or loss if the share price in 14 months is the same as the current share price.  The line ends on the left side at a loss of $33.82 if the share price are zero at the end of 14 months, and it extends infinitely on the upper right hand side (share prices greater than $60 at the end of the 14 month period are possible, but are not included in the chart).

Adding In the Put Option

Here is a summary of some available put options on AT&T with an exercise date 14 months from today (November 20, 2012):

Selected AT&T Put OptionsJanuary, 2014 Exercise Date
Strike Price	Bid	Ask
23	0.57	0.60
27	1.21	1.24
32	2.94	2.98

Because the stock is currently trading at $33.82, all of the put options included in this summary are currently “out of the money”; in other words, the strike price of each put option is lower than the current stock price, so an investor would be better off selling his/her shares at the current market price instead of selling at the strike price of the put options.  The stock price would have to drop to an amount less than the indicated “strike price” at the exercise date (the date when the option expires) for the option to have value (and the further below the strike price, the greater the value).

The “bid” price is the highest amount that a buyer is currently willing to buy the put option, and the “ask” price is the lowest amount that a seller is currently willing to sell the put option.  Because we are looking to buy the put option for our collar, we are focused on the “ask” price.  As you would expect, the price of the put option increases with the strike price as a higher strike price provides the investor with a higher level of protection.

Now, we must select the put option from this list to use in our collar.  The lower the strike price, the more risk the investor is willing to bear; the first put option listed in our table only provides protection if the share price were to drop below $23, while the last put option listed in our table protects against a drop in share price below $32.  Let’s assume that the investor is comfortable with a put option strike price of $23, which means that he/she is willing to tolerate a loss of $33.82-$23 = $10.82 (or 32%) before our protection from the put option kicks in.

The payoff structure of the put option is as follows:

As the chart illustrates, there is zero gain if the share price is $23 or more after 14 months; if, however, the share price is less than $23 the gain on the put option increases $1 for every dollar the share price is below $23, to a maximum gain of $23 when the share price reaches zero.  Remember that a put option gives the investor the right to sell the stock for $23 in 14 months, so if the share price were to drop to $15 the value of the put option would be $23-$15 = $8.

When we combine this with the gain/loss on the underlying share of AT&T stock, the aggregate gain/loss looks as follows:

When the share drops below $23, the gain on the put option offsets the loss on the stock, resulting in a minimum loss of $33.82-$23 = $10.82 (which results at any share price below $23 after 14 months).  Said slightly differently, the put option allows the investor to sell the stock at $23, so he/she would always choose to exercise this right whenever the share price is below $23 in 14 months, essentially imposing a minimum share price of $23.  If the share price after 14 months is greater than $23, the selling price of the stock will equal what it was with just the stock.

Factoring in the price of the put option ($0.60), the net cash flow yield, assuming AT&T pays its expected $1.80 dividend, will drop from 5.32% (from the dividend) to ($1.80-$0.60)/$33.82 = 3.55%.

Adding the Short Call

The arrangement above, simply adding a put option on top of the share of stock, is sufficient to protect the investor against the selected level of downside risk.  However, the price of $0.60 for the put option (and resulting reduced net cash flow yield) may be more than the investor would like to spend for this protection.  An income-oriented investor may, instead, prefer to forgo some portion of potential share price appreciation rather than taking a reduction to near-term net cash flow.

To accomplish this, we can sell a call option.  Selling a security that you do not currently own is called “shorting” the security; because we do not own the call option that we will be selling, we will be taking a short position on the call option.  Here is a listing of some of the available 14 month call options on AT&T:

Selected AT&T Call OptionsJanuary, 2014 Exercise Date
Strike Price	Bid	Ask
32	2.92	2.97
35	1.42	1.46
40	0.41	0.42

As the strike price increases, the value of the call option decreases (because a call option pays an amount equal to the excess (if any) of the share price over the strike price).  Because we are selling a call option, we are focused on the “bid” price; inspecting these prices, we see that the call option with a strike price of $40 has a price ($0.41) that is closest to the put option price ($0.60).  Let’s therefore use this call option in our collar.

The payoff structure of the short call option looks as follows:

If the share price in 14 months closes below $40, the short call option will have zero gain/loss; if, however, the share price closes above $40 the payoff from the call option decreases by $1 for every dollar the share price exceeds the $40 strike price (resulting in a negative value).  Since the investor is on the short side of the call option, he/she must pay the amount of any payoff due under this call option.

Now, the payoff structure on the short call option may look a bit scary as there is unlimited downside risk (as the share price increases, the required payment increases), but remember that the investor owns the stock.  This is referred to as a “covered call” position; because the investor owns the share of stock, the loss on the short call due to the share price increasing above the strike price of the call option is “covered” by the gain on the stock that he/she owns.

Now, adding this short call to the put option and the share of stock results in the following payout structure:

So, here is our final work product!  We have provided downside protection against the risk of share price dropping below $23 by purchasing the put option, and essentially “sold off” the rights to any gain associated with an ending share price exceeding $40 by selling the call option.

Here is a graphical depiction of how the gain/loss changes from the original amounts on just the AT&T stock to the amounts with the collar added, and how the put option and call option payouts affect the change in gain/loss:

As a result, our maximum loss is $33.82-$23 = $10.82 (or 32.00%) and our maximum gain is now $40-$33.82 = $6.18 (or 18.27%).  Assuming AT&T pays its expected $1.80 dividend, the net cash flow yield is now ($1.80 – 0.60 + $0.41)/$33.82 = 4.76%.

Illustration – Dividend Cut

To better understand how a collar could provide some protection on your dividend income, suppose the investor owned 100 shares of AT&T stock, purchased the collar describe above, and that AT&T announced that they were going to reduce their dividend by 50% (so the $1.80 dividend per share is now $0.90).  Let’s further assume that AT&T’s share price dropped 50% to $16.91 (consistent with the dividend discount theory for stock prices) in 14 months.   The put option would pay out 100 x $6.09 = $609, which the investor could use to buy $609/$16.91 ≈ 36 shares of AT&T stock.  The annual dividends that the investor now expects to receive would be 100x$0.90 = $90 from the original shares that he/she owned, plus 36x$0.90 = $32.40 from the additional shares purchased from the proceeds received from the put option, for a total of $90+$32.40 = $122.40.  This is a better result than the $90 in dividends that would have resulted without the put options, but still less than the original $180 we expected before the announced dividend reduction.

Illustration – Dividend Increase

Now, let’s look at what would happen if, instead, AT&T’s doubled its dividend to $3.60 per share and its share price increased 100% to $67.64 (consistent with the dividend discount theory for stock prices) in 14 months.   In this situation, the investor would have to pay 100x($67.64 – $40) = $2,764 under the short call option.  To make this payment, the investor would have to sell $2,764/$67.64 ≈ 41 shares of AT&T stock.  The annual dividends that the investor now expects to receive would be (100-41)x$3.60 = $212.40.  This is still a better result than the $180 originally expected, but less than the 100x$3.60 = $360 that the investor would have received without the collar.

Variation: Increased Net Cash Yield

One way that the collar can be adjusted to better meet the needs or desires of an investor is by adjusting the strike price of the collar to increase the net cash yield.  Referring back to the table summarizing the available call options, you will see that a call option with a strike price of $35 can be sold for $1.32 (vs. the $0.41 at which we sold the call option with the $40 strike price).  If we sold this call option instead, we would get more cash from the higher selling price (at the cost of giving up more upside potential, as we are now passing along all gains associated with a share price in excess of $35 instead of gains associated with a share price in excess of $40).  With this change, the collar actually generates additional cash of $1.32-$0.60 = $0.72 instead of reducing our net cash as in the original example.  Assuming AT&T pays its expected $1.80 dividend, this increases our net cash yield to ($1.80+$0.72)/$33.82 = $7.45%.  However, we lower the maximum potential return from share price appreciation from ($40-$33.82)/$33.82 = 18.27% to ($35-$33.82)/$33.83 = 3.49%.  So, we get a certain $0.92 in exchange for selling the rights to up to an additional $5 in share price performance, which is uncertain (and may be zero).

A Few Things to Keep in Mind

• If you are new to option investing, best to get some assistance from a professional before proceeding with any trading.
• Options are usually sold in lots of 100 (in other words, one option has the right to buy or sell 100 shares of the associated stock), so care should be taken when you buy options that they appropriately match up with the number of shares that you own.
• It would be advantageous from a tax perspective to purchase options that have an exercise date more than 12 months in length and hold them at least 12 months, otherwise gains/losses on the option will likely be taxed as ordinary income (instead of as a long term capital gain).
• Beware of transaction costs, which can add up.  You should also be sure to understand how your broker will charge you for any short positions (e.g. interest charges).
• Consider the impact of taxes (both state and federal) on the performance of your collar, as any gains will typically be subject to a tax.  This may require an adjustment to how your collar is structured.
• Remember you must continue to hold your stock so long as you hold the short call position, as you will need to returns on the stock to pay any returns payable under the short call option; failure to do this will expose you to a potential significant loss that cannot be recouped from the gain on the stock.
• Call options and put options have asymmetric pricing – put options are generally more expensive than comparable call options.  This means that your net return profile with a collar with be lower than without the collar because of this price skewing.
• To maintain a protection on your portfolio, you should hold the put and call option positions close to the exercise date.  If sold prior to the exercise date be sure to immediately replace them with another set of put and call options with later exercise dates.
• Put options do not protect the dividends that you expect to receive before the exercise date – it only protects you against changes in share prices.  Many of our examples assumed that the expected dividend of $1.80 per share were paid (when calculating the net cash flow yield), but this is never guaranteed.
• Option prices will change in future periods, which will affect potential future net cash yields.
• For long positions, you may want to settle prior to exercise date, or be sure you have an automatic exercise mechanism in place with your broker if it ends “in the money”, otherwise there is a risk that the valuable option may expire.  Options must be exercised or sold to benefit from them; it does not happen automatically.

Concluding Thoughts

As I stated at the beginning of this article, I do not believe that dividend stocks should be a primary source of retirement income due to:

1. the uncertainty of future dividends, and
2. the limited capital that most retirees have to fund their retirement

If, however, you feel compelled to pursue a dividend-based income strategy a collar can be a powerful way to reshape the risk-return properties of your portfolio.