CHAPTER 8

The Dividend Collar

The dividend collar is a conservative strategy. It eliminates all market risk of owning stock and sets up a three-part hedge:

Hedging stock risk is accomplished by purchasing one put per 100 shares. Any decline below the put’s strike is offset by increased intrinsic value in the put.

Hedging the put translates to opening a short call, whose premium is used to pay for the put, setting up a no cost of low-cost two-part option position (long put and short call).

Hedging the short call occurs by the purchase of 100 shares of the underlying stock. The short risk is covered, so that exercise of the short call means giving up those 100 shares.

Of course, this three-way hedge requires a working relationship between call and put. If there remains any net debit after opening both positions, it becomes necessary to offset the loss with greater appreciation in the stock. For example, you buy stock at $42 and open two 45 options. You received 0.75 for the call but the put costs 3.00. This is a debit of 2.25 ($225). However, exercise of other option produces a net profit of $300 (strike of 45 less cost of 42). Overall, this is a net profit of $75 ($300 - $225). This means you can afford a debit between the two options if exercise of either creates a net capital gain higher than the debit.

Even so, the “ideal” dividend collar consists of a short call and a long put whose net is zero or a small credit. This is difficult to locate with a strike at or above current value of the underlying stock. As the price of stock declines, the cost of the put rises while the value of the call declines. Examples of a working dividend collar can be found, in which the options net out to zero or better, and exercise produces a small capital gain. The purpose in opening such a position is to ensure earning the current month’s dividend without risk of price decline in the stock.

Is this possible? Yes. While dividend collars are difficult to find, they do occur often enough so that you can earn a current dividend every month by rotating in and out of stock positions. In most cases, the parity between call and put will not work, or the price of the underlying stock is too far from the desirable strikes to make the strategy work. However, a diligent examination of ex-dividend dates coming up between today and the next expiration date for options does reveal opportunities that work.

The most practical timing of the dividend collar is when stock is already held in the portfolio and has appreciated in value since purchase. In this case, it is possible to identify a working collar that also builds in a net capital gain in stock in the event the short call is exercised.

This is a difficulty strategy to find without involving appreciated stock. However, the dividend collar is effective as a portfolio management strategy. When you are holding appreciated stock, you are concerned about possible loss if the stock price declines. At the same time, you would prefer to continue holding the stock for further appreciation as well as dividend yield. This is where the dividend collar is worth executing.

Managing Portfolio Profits with the Dividend Collar

Entering a dividend collar with the purchase of stock and trading of both options, all at the same time demands research and patience, but when the right trade is found, it produces double-digit annualized returns.

The three issues in the model portfolio provide examples of how the dividend collar serves as a method for removing market risk and earning the current dividend. These are set up with the assumption that shares were purchased at a price below the current price per share. These are summarized in Table 8.1:

Table 8.1 Three examples of the dividend collar

Symbol	Name	Shares	April 25, 2019 Price ($) Value ($)		January 20, 2016 Price ($) Value ($)		Net gain
T	AT&T	1,400	30.34	42,476	28.55	39,970	2,506
SO	Southern Co.	800	52.44	41,952	39.89	31,912	10,040
MO	Altria	800	51.41	41,128	49.84	39,872	1,256

The timing was selected to demonstrate how appreciated value of a portfolio makes it easier to enter a dividend collar position. The dividend collar can be set up as of the later date to protect paper profits and ensure that dividends will be earned in the next cycle. Table 8.2 summarizes a range of available calls and puts and their pricing as of April 25, 2019.

Table 8.2 Options for dividend collar positions

Symbol	Price ($)	Ex-dividend date	Calls Strike Bid		Puts Strike Ask
T	30.34	Jul	MAY 30	0.75	MAY 31	0.93
SO	52.44	Aug	JUN 52.50	0.94	JUN 50	0.55
MO	51.41	Jun	JUN 52.50	1.29	JUN 50	1.57

Source: Charles Schwab & Co.

Many options beyond these are also available. However, this set of choices work well for the purposes of the dividend collar to create a risk-free position in the stock (with strikes of options above original basis) at little or no cost.

Each of the choices can be studied to determine the range of outcomes in event of (1) having the short call exercised, (2) rolling the short call forward to avoid exercise, or (3) exercising the long put due to a decline in the stock price.

For example, AT&T was bought at $28.55 per share, and currently is priced at $30.34. This is a paper profit of $2,506 for 1,400 shares. The quarterly dividend is 0.51 per share, or $714 for 1,400 shares. The dilemma here is that you want to protect the $2,506 in profits, but you also want to earn the $714 quarterly dividend. The dividend collar solves this problem with three possible outcomes.

The 31 call moves in the money and the call is exercised. In this outcome:

Capital gain, $2.45 per share, 1,400 shares	$3,430
Profit on net option credit, 0.75 per share	$1,050
Total profit $4,480

The call moves in the money and the call is rolled forward. In this outcome, the roll delays, avoids exercise, and sets up a credit, which is determined by the premium for the new call. However, this also extends the period of exposure for the covered call.

The put moves in the money as stock price falls, and you exercise the put. In this outcome, the net cost of the options is $18 per share ($93 - $75), or $252. You can exercise at the put’s strike of 31 and receive $31 per share or $43,400 versus original cost of $42,476. This creates a capital gain of $924. With the net cost of the collar at $252, this creates a net profit of $672 ($924 - $252).

A similar analysis can be performed for Southern Co. or Altria. The purpose of the dividend collar is to protect current paper profits from appreciated stock (with the long put) and pay for that hedge (with the short call). In all the possible outcomes, several portfolio management advantages are gained:

1. Creation of profits from multiple sources (capital gains, option net credits, dividends, and rolling forward).
2. Downside risk is removed by the long put, which will gain one point in intrinsic value for each point the stock declines below the put’s strike.
3. Dividends are earned (except when early exercise occurs), meaning the stock is held risk-free and dividend income is earned as well.
4. The option hedging positions of the dividend collar do not cost anything. In fact, they create net credits, adding to overall net income.

The next chapter moves beyond the conservative strategies based on the combined use of stock and options and explores contingent purchase strategies and rescue strategies, designed to recapture losses and return positions to breakeven or better.

Class questions for discussion and/or mini-case studies

1. The dividend collar sets up:

   a. A three-part hedge involving long stock, long put, and short call.

   b. A two-part hedge in which call and put offset one another, but no stock is owned.

   c. Protection of the dividend through a long put without hedging attributes.

   d. A way to earn dividends without owning stock for any period.

2. In the dividend dollar:

   a. Long calls are paid for with short puts.

   b. Long puts are paid for with short calls.

   c. Puts and calls are both short, generating cash profits.

   d. Puts and calls are both long, paid for with capital gains on stock.

3. Exercise may be a desirable outcome of the dividend collar, when the basis in stock:

   a. Is higher than the strike of the short call.

   b. Is lower than the strike of the short call.

   c. Is as close as possible to the call’s strike.

   d. Is matched exactly to the long put’s strike.

Discussion

Identify a potentially profitable dividend collar on appreciated stock and explain the three possible outcomes: short call is exercised by someone else, you exercise the long put, or the short call is rolled forward.