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Make the most of high-dividend stocks

Posted
4/7/2014 8:00:00 AM
By: InvestorsObserver
Referenced Stocks:DVY;LMT;CVX;ETR;PM

Michael Fowlkes 04/07/2014

Investors love seeing dividends hit their portfolios. Owning a nice selection of dividend-paying stocks is the perfect way to add income to your portfolio, and spruce up the return on your investments.

Dividend-paying stocks are attractive for more reasons than just the periodic influx of cash, or reinvested stock, into your portfolio. Stocks that are solid dividend payers tend to be a bit more stable than the broader market. The dividends keep investors interested in the stock, and they are a signal that management has enough confidence in the company underlying business to return cash to its shareholders.

When the markets run into trouble, one of the first places investors flee to is dividend stocks , so they also offer a bit of a cushion in a down market.

In summary, dividend-paying stocks tend to represent mature companies, with solid underlying businesses that have the confidence of management, which also happen to bring income into your portfolio. These are all very good reasons to consider investing in a basket of high-dividend paying stocks.

However, one of the traits that make them so attractive is also a trait that can lead to investor frustration, which is their stability. As traders, we like to watch our stocks rise faster than the markets. But this is not exactly how stable stocks perform. If the market enjoys a sharp bullish rally, dividend stocks are likely to underperform, or at least not outperform the broader market. This is the tradeoff you accept in exchange for owning stocks that will lose less during a down market.

So the question that arises is how can we take advantage of the stability of high-dividend paying stocks, while at the same time boost our returns enough to outpace the broader market? The answer can be found in the options market, which allows us to set up hedged option trades on dividend stocks that have target returns much higher than you can expect should you simply buy the underlying security.

To add another layer of security to our trade, we can opt to diversify our investment by trading a large basket of high-dividend stocks in just one trade by setting up a trade on the exchange-traded fund iShares Select Dividend ( DVY ).

DVY is set up to track the results of the Dow Jones U.S. Select Dividend Index, which is composed of the relatively high-dividend-paying stocks in the U.S. market.

The following stocks make up the fund's top five holdings, along with their current dividend yields:

  • Lockheed Martin ( LMT ): 3.3% yield
  • Chevron ( CVX ): 3.4% yield
  • Entergy ( ETR ): 5.0% yield
  • Philip Morris ( PM ): 4.6% yield
  • Kimberly-Clark (KMB): 3.1% yield

As you can see from the above list, not only are you taking advantage of the stability of high-dividend paying stocks, but your investment is also spread over a diversified group of stocks.

In order to boost the potential return possible with a trade on DVY, we can set up a hedged trade on the ETF which would provide a good return even if DVY happens to trade lower during the life of the trade.


Chart courtesy of stockcharts.com

A nice hedged trade on DVY would be the September 65/69 bull put credit spread. To set up this trade, you would sell the September 69 put while buying the same number of September 65 puts for a credit of 30 cents. This trade has a target return of 8.1%, which is 17.5% on an annualized basis (for comparison purposes only). DVY is currently trading at $73.65, which gives this trade 5.9% downside protection.