High Dividend Stocks - Protecting Yields and Lowering Risk

With the recent rash of dividend cuts by historically dependable dividend-paying companies, income investors are finding it increasingly challenging to find safe high dividend yields. Indeed, Standard & Poor's expects 2009 to have the biggest drop in dividend payouts since 1942. The market decline has created many accidentally high dividend stocks, as companies who've maintained their dividend payouts in spite of share price declines suddenly find themselves paying out record high dividend yields. The other edge to this sword is that many companies are slashing their dividend payouts to conserve cash, reasoning that their lower payouts still offer a strong yield, given their lower share price.

In addition, the increased volatility associated with the market's decline has devalued investors' principal, leaving them with less capital to invest, if they choose to re-balance their portfolios.

A useful, conservative strategy that actually capitalizes on the market's volatility to lock in high dividend yields is the Covered Call Selling or Buy/Write technique. The increased market volatility has increased call option premiums, giving investors the opportunity to sell high yield covered calls on many stocks, in effect giving them a one-time "double dividend", reducing their initial investment cash outlay, and also offering them some downside protection. Since no company can cut the premium on their call options, these instruments are tantamount to an "ironclad" dividend. Indeed, the current call premiums are often giving investors higher yields than the underlying stock dividends. So, even if the company does cut its dividend, the investor will still retain the premium from his covered call sale. In addition, a call seller receives the call premium money back into his account upon settlement, (usually trade date plus 3 days).

Covered call writing also gives you the potential for capital gains, in addition to the high yields that you get from the call premium/dividend yield, should the stock be assigned, (sold), at expiration. Investors often sell covered calls that are approximately 5-20% above the stock's current price, giving themselves the potential to realize an additional 5-20% profit, should these stocks rise past the covered call thresholds by the end of the investment term. Given the historic lows that many companies' share prices have fallen to, many traditional value investors feel that they are buying these stocks at undervalued prices, and reason that there's a very good chance of them rising in the future.

To illustrate this technique, let's take a look at the prices for NYSE/Euronext (NYX), as of March 4, 2009 market close:

STOCK COST/ SHARE:$16.36 ANNUAL DIVIDEND:$1.20/SHARE DIVIDEND YIELD:7.33%

CALL STRIKE PRICE:$17.50 CALL PREMIUM:$3.25 STATIC CALL YIELD: 19.86%

CALL EXPIRATION DATE: JAN. 15, 2010 TOTAL STATIC YIELD: 27.19%

TOTAL POTENTIAL ASSIGNED YIELD: 34.16%

As you can see from the yields in this example, this stock's 19.86% call selling yield is 2.7 times its dividend yield of 7.33%. So, even if they were to cut their dividend, the investor in this example would still have nearly 20% downside protection.

If the dividend remains intact, the total downside protection in this trade is 27.19%, equivalent to the total static yield, (the combination of the dividend and call yields). In addition, by selling a call at the $17.50 strike price, approximately 7% above the $16.36 cost/share, this investor also has the potential to for a total assigned yield of 34.16%, making a very compelling case for this strategy.

Trade Summary for this Example:

Breakeven: $11.91

Maximum Share Reselling Price: $17.50

Static Yield: $435.00

Potential Assigned Yield: $559.00

Static Call Yield: The yield realized when the underlying shares are NOT assigned/(sold) at or before expiration. In a "static" scenario, the stock's share price doesn't rise above or close enough to the combination price of the strike price, plus the call premium, to make it worthwhile for the shares to be bought by the call buyer on the other side of the trade. In the above example, the share price would have to rise above or near $20.75, ($17.50 strike price plus the $3.25 call premium), to make it worthwhile for the call buyer to exercise his option to buy your shares.

Total Static Yield:The combination of the dividend yield and the static call yield.

Assigned Call Yield: The yield realized when the underlying shares ARE assigned/(sold) at or before expiration. This normally occurs when the stock's share price rises to or above the combination price of the strike price, plus the call premium, causing the shares to be assigned, (sold), at the strike price, which in the above example is $17.50.

Risks and Limits: As with any investment, there are risks. Obviously, this strategy can't guarantee that these stocks won't decline further in value once you've bought them. However, this value-based, "double dividend" covered call strategy will at the very least give you more downside protection than if you had only bought the stocks outright, and the call premium lowers your cost basis.

Upside Risk: Since this strategy quantifies the upper limit of your profit potential, you should be aware that, even if the stock appreciates far past your strike price and call premium, you'll still be obligated to sell it at your covered call strike price, which places a limit on your profit potential. It's usually wise to research the call's theoretical value in an options pricing model, such as Black-Sholes, before placing the trade, to ascertain the chances of the call ending up in the money at expiration. You should always analyze your static and assigned gains, and breakeven point before placing any Covered call, (Buy/Write), strategy. Many of the online brokers have automated options pricing calculators that simplify this process.

Downside Risk: The biggest risk factor in selling covered calls is that you are putting much more money at risk here than by merely buying a call option. However, research has shown that the odds tend to favor option sellers over buyers.

You should make sure you research any stock thoroughly before executing this or any other strategy.

However, as noted before, if the stock declines past your breakeven, you should be able to offset some of the loss by "buying back in" your sold calls at a profit, and perhaps rolling into a lower strike price call, if you want to maintain your underlying position.

Robert Hauver publishes The Double Dividend Stock Alert, a monthly newsletter featuring high yield strategies for value and income investors. Website: http://www.DoubleDividendStocks.com copyright 2009 DeMar Marketing. All Rights Reserved Worldwide. This article was written for informational purposes only. Readers should not make any investment decisions based solely on the information in this article. Article Source: http://EzineArticles.com/?expert=Robert_Hauver