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A New Option for Portfolio Management


The S&P 500 Dividend Index is set to begin trading on Friday.

The Chicago Board of Options Exchange is set to launch a new product based on the recently created S&P 500 Dividend Index. The index, which goes under the ticker symbol DVS, is designed to track the total dividends of the constituents of the widely followed benchmark S&P 500 Index. The options, which are set to begin trading on March 5, could provide a valuable tool for portfolio management.

While I don't expect the options to become a hot-spot destination for active traders and many of the applications will have more appeal to professionals and institutional money managers than retail investors, they could still have a proper place in a self-directed investor's arsenal.

Dividends have always been an important component in determining expected total returns. Stocks that pay dividends are at the core of many people's long-term holdings whether they take the form of exchange-traded funds, mutual funds that focus on value, or income. Dividend payments are a core element and have a huge impact, especially when reinvestment and compounding are assumed in structuring a portfolio that will deliver returns within a given range of risk expectations.

But as we've seen over the past few years, even some of what were considered the safest companies, such as General Electric (GE), were forced to cut or even eliminate their sacred dividend. People that had been concentrated in sectors such as utilities, financial services -- like insurance companies, which typically had reliable payouts -- and even ETFs such as the Spyder Financial Select (XLF) had experienced a double whammy of equity loss and reduced income.

The Dividend Index options could provide a tool for not only hedging against dividend risk but also employing strategies that benefit from general trends of declining or rising dividend payments.

So while dividends have, in general, been declining over the past two years, they now appear to be on the upswing. According Standard & Poor's the current yield on the S&P 500 Index is 2.06%, up from 1.72% at the end of 2009. That number should move higher as companies such as AT&T (T), Pfizer (PFE), Waste Management (WM), and General Mills (GIS) have all announced dividend increases in the past quarter.

How It Will Work

The structure and mechanics of the S&P 500 Dividend Index is somewhat complex and so is the nature of dividends to the derivatives -- remember dividends are one of the key components that are used in option pricing models -- but it essentially represents the ordinary cash dividends for corporations comprising the S&P 500 Index, accumulated over a quarterly "accrual period." The index will provide a running total any given day by dividing dividend points by the index divisor. Thus the index measures the total dividend points of the S&P 500 since the previous reset date. Investors will have the ability to trade the difference between the expected dividends during an accrual period and the actual dividends over that same period. The index will be reset to zero after the close on the third Friday of the last month of every calendar quarter to coincide with futures and options expirations. For more details and contract specifications one can look at the CBOE website.

Dividends have always played an important role in investors' decision-making processes, especially when planning for the long term. Being able to isolate and reduce that risk should be welcome during these uncertain times.

For more from Steve Smith, take a FREE 14 day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.
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No positions in stocks mentioned.

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