Using Options to capture fixed income dividends

Posted on March 21st, 2012

In last week’s article on hedging your fixed income ETFs (click here to see it), we promised a follow-up article on using spreads on fixed income ETFs. In particular, we thought we would explore how put spreads capture part of the dividend from the ETF – even though you don’t own the underlying ETF.

Consider the Bull put spread – where you sell the In-the-Money put on the fixed income ETF and simultaneously purchase an out-of-the-money put for the same expiration month. Most fixed income ETFs pay a dividend every month – so the options prices for the fixed income ETFs are heavily influenced by the cash flows of the dividend.

The higher the yield paid on the ETF, the higher the influence on the options price. A high yield ETF like JNK has its options prices more influenced than a investment grade fixed income ETF like LQD which has a lower dividend yield. This should make sense on two levels: first, the cash flows paid to the high yield are higher so these higher cash flows need to be considered in the on-going value of the ETF. Second, a high yield ETF is higher risk than an investment grade ETF. Higher risk is often expressed thru the volatility of the price of the ETF. We all know that higher volatility means higher extrinsic value in the option.

When you price the spread, you will notice that a bull call spread has materially lower total extrinsic value than a bull put spread with identical strike prices. The reason: the bull put spread gets paid the dividends (more accurately the discounted value of the dividends) to the short put seller (ie, you in this case if you are placing the bull put spread). In other words, the bull call spread reflects only the time value you must pay to be in this trade – while the bull put spread reflects the same time value + plus some discounted value for the dividends.

Let’s look at an example for a bull put and a bull call spread that expires in September 2012 in the JNK at the strike prices of $37 for the floor & $41 for the upside. JNK is trading this afternoon at $39.55 – down about 7 cents for the day.

The bull call spread has no time value – it trades at just about the intrinsic value only – meaning the call you sold (small amount) covers the small time value you sold in the out of the money call. So, you effectively could collect the appreciation in this ETF up to $41 for no time value – but would not collect any dividend which is a key part of this ETF’s overall return. Of course, you would also experience the downside down to $37.

In the bull put spread, however, you would be in a credit spread – meaning you would collect more premium than you paid. The $41 put would sell for $3.15 mark and the out-of-the-money put you bought would cost about 82 cents. You would net $2.33 cents paid to you to enter this trade. The ITM put has $1.45 worth of intrinsic value – meaning you are collecting 88 cents of time value.

You paid 82 cents for the OTM put protection. So, the ITM put has $1.70 in extrinsic value. You expect to collect $1.44 in dividends over the next 6 months if you held the ETF – so there is 26 cents in time value you get paid for giving up the upside over $41.

You collected 26 cents in time value for giving up your upside at $41 and paid 82 cents in time value for the downside protection at $37. That means you were out of pocket 56 cents to get in to this hedged trade in the JNK ETF. But you also collect the dividend at $1.44 – and you collected it now. So, you got yourself in to a dividend yielding position and was able to use about 40% of the dividend (40% times $1.44) to fund paying for the hedge.  You now have fixed income ETF exposure – that is hedged AND uses low capital requirements.

Not too bad – which is why we like this kind of position to create fixed income exposure. It can be used with other fixed income ETFs like LQD.

So, if you want to own fixed income ETFs and you aren’t afraid to use options to express the position, you can feel free to give it a try – just remember two things: (1) the discount to the dividend matters so calculate what it is before you make the trade; and, (2) this approach requires regular position turnover to maintain so it is best placed in a tax-advantaged account like an IRA.

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