What if you could go back 7 years to the very top of the stock market bubble, what would you do differently? What if you could have bought insurance on the performance of the stocks in your portfolio?
There exists a strategy that protects the investor from both downside risk and opens it up for unlimited profit potential. It is the same as an insurance policy, you pay a little as you go along, for protection against loss. Today there exists opportunities that provide investors with an at worst loss of $0.00 and an unlimited profit potential over a two year period. As with everything dealing with the stock market, there is never a free lunch, and yes there is a time value to your money, that even though you might have a realized loss of zero, you may have less buying power in the future.
The strategy is a well known strategy known as a “Protective Put” or “Married Put“, which involves purchasing an interval of 100 shares of a particular stock and buying one put option per 100 shares purchased. The key to the low-risk strategy is that the investor looks for companies that pay a dividend, usually greater than a 3.00% annual dividend yield. Basically the investor will be long 100 shares of stock, each yielding a 3% a year, which that money will be used to finance the premium paid for the put option(s).
Lets use an example to clarify the point:
Altria Group (MO) currently trading at $88.00. You purchase 100 shares, for a total of $8,800. You purchase one January 2009 $90 Put option on the position at a cost of $8.80 per share, for a total cost of $880. The total cost of the position is $9,680. The position has a breakeven point of $96.80, or a 9.5% premium to the $88.00 it is currently trading at. Now this may sound like a bad bargain the investor, but the fact is that Altria pays a dividend of $3.44 per share or a yield of 3.90% a year. The put option has two years till expiration, meaning that until the put option expires, we collect $6.88 per share or $688.
Here is a breakdown of the possible outcomes and returns after two years:
$90 or Below - +$44 or a return of .45%
$95 - +$548 or a return of 5.7%
$100 - +$1,048 or a return of 10.9%
$105 - +$1,548 or a return of 16.1%
Positive returns exist in all scenarios of the above transaction. While this strategy would not fit some investors profiles, because it does take away some of the upside because of the premium paid on the put option. The fact is that following the bubble in 1999 and 2000 stock prices plummeted and some have never returned to that level. The ability to finance insurance with a dividend is a fail safe strategy that can show a profit in any market environment. While the returns probably won’t exceed the S&P 500 during a bull market cycle, it will for sure outperform and preserve your capital during a bear market and/or stock market crash. The fact is also that dividend stocks tend to perform better in bear markets, this strategy combines the ideas of both principles and creates low volatile, positive returns.
This analysis did not take into account transaction costs and taxes.
