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Using the Dividend Timing Collar in Options Trading


For a trader with some finesse, this strategy can eliminate volatility risk while creating double-digit returns on dividends.

Dividend yield all too often is overlooked by options traders. However, dividends may represent a significant portion of total return. There is one system that reduces market risk while converting dividend yield into double digits. The dividend timing collar requires maintenance but can create a very attractive level of net return.

The strategy involves several pieces:
  1. Ownership of 100 shares of stock for each increment of the collar.
  2. Opening a collar, a short call, and a long put.
  3. Timing the strategy so the trader is stockholder of record right before the ex-dividend date.

Each of these pieces requires careful timing and selection. To work best, both options should be scheduled to expire within less than one month. This is so because the strategy works best if the call and put are either closed, exercised, or expired as quickly as possible (specifically, before the ex-date of the following month).

This strategy accepts exercise of the call if stock prices rise, and enables the trader to exercise the put and dispose of shares if the stock price falls. Either outcome is break-even or profitable as long as options are selected properly. The ideal situation is to open options at the money or with strikes as close as possible to current price.

The cost of the put should be mostly covered by income from the call. It may even create a small net credit in some cases.

The strategy can be repeated every month (or even more often). In the one-month approach, the trader needs three stocks. Each one has ex-date in a different month. So the dividend timing collar is opened in January right before ex-date and using January-expiring options. The stock will be exercised away via the short call or the long put, or closed by the end of the month at break-even or better. This frees up the same capital to next open a February collar right before the February ex-date. This is continued month after month.

The net effect is that stock is held only long enough to earn the quarterly dividend. So assuming all three stocks earn 4% per year, this translates to a quarterly return of 1%, each and every month. Annual return is then 12%.

The market risk is completely eliminated as well. If the stock price rises, shares are called away by exercise of the short call. If the stock price falls, the trader exercises the put and disposes of shares at the put's strike.

What can go wrong? The call could be exercised before ex-date, meaning the trader loses shares and the dividend income. At this point, the call ceases to exist and the trader is left with a no-cost or low-cost long put. There is also the occasional lost opportunity cost if and when share price rises significantly above the call's strike. However, this is not a stock or option strategy by itself; it is a strategy designed to achieve three goals: (1) elimination of market risk in the long stock, (2) opening of option positions at little or no cost, and (3) creation of double-digit annual return from dividend yield.

The beauty of this strategy is that it allows traders to chase high dividend yield without having to worry about stock volatility. In this strategy, high volatility in either direction is an advantage. Traders want to own stock to earn dividends, and then get out and go to the next position.

Twitter: @MichaelThomsett

For more on options trading, take a 14 day FREE trial to OptionSmith. Get access to veteran options trader Steve Smith's portfolio along with emailed alerts and strategy with every trade he makes. Learn more.

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No positions in stocks mentioned.

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