An Income Strategy With Double-Digit Downside Protection

The bull market could soon look weak as revenue growth slides and fear of Fed tapering risks the economy falling back into recession. Investors need to start thinking about capital preservation with safety investments. The fact that bonds and the typical safety stocks may not offer their historical protection means that investors need to look to other strategies. The covered call strategy with deep-in-the-money calls against solid, dividend-paying stocks could offer downside protection and returns to beat other safety plays.

Rates and the herd are changing the game

If you are a later-stage investor or just someone that is uncomfortable with a lot of risk, bonds have traditionally provided the safety and income you needed. Returns have never been as sexy as stocks or other risky investments, but you could depend on the stable portfolio value and regular cash return. With rates surging more than a percent so far this year off of historic lows, bond prices are taking a beating and safety of capital is no longer so safe. While bonds held to maturity will still pay the par value, many investors have positioned in exchange-traded bond funds which don’t benefit from the same maturity deadline. Besides the risk to value, rates are so low that few can live off the yield provided by short-term, high-rated bonds.

In the search for that livable income-yield, investors have followed risk higher to junk bonds and into shares of consumer staples. The companies sell the most necessary products and have always had relatively stable revenue growth but are now proving that no sector is safe from a stock bubble. A four percent dividend does little good if the shares tumble 10% from historically pricey valuations.

Owning the stream without really owning the stock

As rates and the rest of the market push you out of your favorite income and safety investments, you need to look to strategies to provide the same objective. One such strategy is selling deep in-the-money call options against solid dividend stocks.

The covered call strategy is nothing new, selling the right to buy your shares away at a certain price on a certain date. The typical strategy involves selling call options above the current price so that you maintain some upside price potential on the shares.

Selling call options well under the current stock price allows you to keep the dividend stream while not having to worry too much about losses on the shares. Your ultimate return on the shares may only be a couple of percent, at best, but the cash return can mean total yield above 6% each year.

The strategy is not completely without risk. If stocks tank then you could still be looking at a loss on the shares. Deep stock losses are not necessarily a bad thing with the strategy. If the shares close below the call strike on expiration, you keep the premium and the shares. Your cost basis for the shares is extremely low and you can take advantage of a market rebound.

In the more likely event that the shares close above the strike, you either sell the shares or buy-back the calls. Any loss on the call position can be taken to offset taxes in other gains. Selling long-dated options can help control the tax implications of the strategy.

Cash cows for the long-term

I have used this strategy in the past and increased my use during the second quarter when the Fed’s tapering outlook started to weigh on the market. I only use the strategy with stocks that have strong cash flow and predictable revenues over the long-term. If the market or the stock comes down hard, I only want positions in stocks that I would not mind holding onto until a rebound. As with any portfolio strategy, make sure you have a diversified mix of sectors and revenue drivers.

Lorillard (LO) had $2.90 a share in free cash flow last year, more than enough to cover the $2.20 per share dividend for a 5.1% yield. Your feelings about smoking and tobacco aside, you cannot deny the resiliency of the business model. The company has hiked the dividend by an annualized 12% over the last five years, giving longer-term investors additional gains. Selling the January 2015 calls with a strike of $38.33 lowers your cost for the shares to $36.55, for a 17% protection on any losses. If the shares close above the strike, you book a 4.9% return on top of the 5.1% annual dividend.

The company recently won the first two clearances by the Food and Drug Administration (FDA) to market new tobacco products since 2009. While U.S. unit sales for cigarettes have been in decline, the company has positioned itself into e-cigarettes which have benefitted from a lack of regulation and faster growth.

Darden Restaurants (DRI) had $2.03 a share in free cash flow in fiscal 2013, just short of its $2.20 per share dividend and 4.4% yield. Though free cash flow was weaker last year, the company has been able to increase the dividend by an annualized 22% over the last five years. Estimates are for revenue growth and stabilization in earnings this year with faster growth next year. Over the longer-term, the company manages some of the strongest brands in restaurants including Olive Garden, Red Lobster and Longhorn Steakhouse with more than 2,100 locations.

Selling the January 2015 calls with a strike of $40.00 lowers your cost for the shares to $39.29, for a 19% protection on any losses. If the shares close above the strike, you book a 1.8% return on top of the 4.4% annual dividend.

Eli Lilly & Company (LLY) had $3.95 a share in free cash flow last year, more than twice the $1.96 per share dividend. The high amount of free cash flow and the fact that the dividend has not been increased since 2009 leads me to believe than an increase could be announced soon. Before 2009, the company had raised the dividend by an annualized 7% over the previous five years. As with all drug makers, the company must keep its pipeline fresh to ensure revenue growth but it benefits from an extremely strong demographic tailwind over the long-term.

Selling the January 2015 calls with a strike of $45.00 lowers your cost for the shares to $43.97, for a 17% protection on any losses. If the shares close above the strike, you book a 2.3% return on top of the 3.7% annual dividend.

One of the company’s experimental drugs, necitumamab, has been shown to increase survival in patients with advanced forms of cancer. The drug is expected to be submitted to regulators next year for approval which could significantly boost sales in the future. The company has also recently seen positive results showing its experimental diabetes drug dulaglutide helps patients lose weight with manageable side effects.

Seagate Technology (STX) had $6.33 a share in free cash flow last year, well over the $1.52 per share it needs to cover the dividend. Along with other cyclical tech companies, Seagate tech cut its dividend during the financial crisis but has since returned to its commitment to return cash to shareholders. The company has more than tripled its dividend since 2008. CEO Stephen Luczo recently admitted that the company was looking into software companies as acquisition targets to help fill out its ability to meet demand for cloud computing. Valuations may be relatively high right now but Luczo was positive on the company’s opportunities over the long-term.

Selling the January 2015 calls with a strike of $27.00 lowers your cost for the shares to $26.19, for a 35% protection on any losses. If the shares close above the strike, you book a 3.1% return on top of the 3.9% annual dividend.

Adjustable strategy to provide income and safety

You can try the strategy with any optionable stock. I only trade the options with more than a year left to expiration. These offer higher premiums, reduce trading costs and give you more flexibility in tax planning. When you sell the call options, always place a limit order at the midpoint price or higher otherwise you risk collecting a lower premium at the bid price.

Avoid the temptation to sell calls closer to the current stock price for a higher price return. This is a respectable strategy but leaves you open to larger losses if the market hits a speed bump. Stick with the strategy for a stable cash return and safety of principal.