Many of you have been inquiring recently about a whether or not we are going to “Hedge” the Model Portfolio soon and we wanted to offer up some thoughts and a strategy for you to consider in the coming weeks.

First and foremost, it’s important to remember that market corrections happen. As a matter of fact, we would add market corrections to the list of things in life that are guaranteed. Just like death and taxes, market corrections are a way of life. That said, investors need to EXPECT, and more importantly, PLAN for major corrections.

Investors can plan for a market correction by taking the necessary steps to hedge their portfolio. In our opinion, a protective put hedge strategy is the easiest and most cost-effective way to hedge a portfolio.

Protective Put Strategy Overview

The main purpose of hedging your dividend portfolio is to limit your downside market exposure (i.e., protect your capital base), while keeping your dividend income intact. As we said above, we believe that purchasing a protective put is the easiest (and most cost effective) way to hedge your portfolio.

We like to use options on the S&P 500 ETF (SPY) for our protective put strategy. Remember that we are only trying to “hedge” the general market exposure in our portfolio and the S&P 500 is a great proxy for the general market. In addition, SPY options are extremely liquid, which makes them very easy to trade.

No hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. Whether or not you decide to hedge your own DIY Dividend Portfolio will depend on your specific market outlook and risk tolerance.

Note:  If you are unfamiliar with options, there are some great free websites out there to educate yourself (like the Option Industry Council).  Also, we will be completing our options e-book in the next few months (which will be free for all Premium Members) that will certainly help educate you on the conservative option strategies that we use for the Model Portfolio.

Hedging 101 (Step-By-Step)

As we have previously discussed, we expect stocks to continue to be strong out of the gate in 2013, but we do believe that this rally is more of the “relief” variety. There are still a lot of moving parts that Washington is pushing around and the debt ceiling debate will intensify over the next several months. We definitely think that stocks will finish 2013 on a positive note, but we believe that the next 3-6 months will remain volatile. That said, since we won’t be able to time the market top, we feel that now is as good of a time as any to start implementing a short-term “hedge” for the portfolio.

Below is a step-by-step procedure that we follow when implementing a protective put strategy. Hopefully, this will help you implement a similar strategy for your own portfolio.

Step #1:  Determine How Many Puts to Buy

Every portfolio is different, but the weighted average Beta of your portfolio is a good metric to use to estimate your portfolio’s general market exposure (i.e., systematic risk). For example, if your portfolio Beta is 0.50, the volatility of your portfolio should theoretically only be half that of the general market (i.e., if the market declines 1%, your portfolio should only decrease 0.5%).

For example, we currently have approximately $270,000 of long stock exposure in our model DIY Dividend Portfolio, with a weighted average Beta of 0.74.  Theoretically, if the S&P 500 declines 10%, our model portfolio should only decline 7.4%.  That said, we need to buy approximately 14 SPY puts to hedge our portfolio:

Underlying Value of 1 SPY Option Contract:                      $146.00 x 100 = $14,600

Contracts Needed to Fully Hedge Portfolio:                        $270,000 / $14,600 = 18.49 Contracts

Beta-Adjusted Contracts:                                                                  18.49 x 0.74 = 13.68 Contracts

Note: We have a FREE spreadsheet on our website that will help you calculate the weighted average beta of your portfolio as well as the number of put options you need to implement your hedge.

Step #2:  Determine a Strike Price and Term

In general, we prefer shorter term options (less than 3 months until expiration) over longer term options and we prefer “in-the-money” options over “out-of-the-money” options. We have these preferences because we try to limit the “time value” exposure in our protective put. In other words, we want as much “intrinsic value” as possible in our put option. For put options, the intrinsic value is the difference between the strike price and the underlying’s stock price and we want the value of our put option to track as closely as possible to the underlying change in the price of SPY.

Choosing a strike price and expiration date for your put option is ultimately a personal decision. Some investors may prefer longer-dated options because they have to be “rolled” less frequently or they may prefer “out-of-the-money” options because they are less expensive. However, these decisions will ultimately affect both the cost of the hedge as well as the degree of protection that the protective put will provide. So it is critical that you understand the trade-offs of these decisions before implementing this strategy.

That said, we are targeting the Q1 Mar 2013 Put options, which will give us almost 3 full months of protection (and it will us coverage through the upcoming debt ceiling deadline).  As expiration of this option approaches, we can reassess the market to determine whether or not we want to roll the position for another few months.

As far as strike price goes, we try to purchase a strike with a Delta of .60-.70. Without getting too technical, an option’s delta can be used as a proxy for the probability that the option will finish in-the-money. In other words, an option with a delta of .70 theoretically has a 70% chance of finishing in-the-money. The higher the delta, the greater the intrinsic value (and the greater the cost)…so there is definitely a cost/benefit tradeoff when picking a strike price. That said, we are targeting a strike price in the $150.00 to $152.00 range for the Q1 Mar 2013 put options.

Step #3:  Determine How Much Protection You Think You Need

Timing is everything when using options and it’s important to estimate how low you think the market could go (over the term of the option period) so that you will be properly protected. The obvious tradeoff of buying a protective put for your portfolio is…cost!

The key takeaway here is that you shouldn’t pay for what you don’t need.

You can offset part of the cost of a protective put by selling an out-of-the-money put with a lower strike price (and the same expiration). Essentially this would create a “put spread”, where you would limit your maximum profit (but it will also lower your cost of protection).

For example, since we think that the market could drop 5% between now and the end of March (which would equate to SPY falling to approximately $139.00), we would consider selling the Q1 Mar 2013 put that has a strike price of $139.00. In other words, this spread position will protect us from a market correction up to 5%.  However, if the correction is greater than that (i.e., if SPY drops below $139.00), our portfolio will be unhedged. This is why it’s important to really think about how low you think the market could go before you decide whether or not you want to sell an option with a lower strike to reduce the cost of your hedge.

Summary

Implementing a protective put strategy may seem daunting at first, but it is actually quite easy to execute if you follow these 3 simple steps.

Remember that no hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. Whether or not you decide to hedge your own DIY Dividend Portfolio will depend on your specific market outlook and risk tolerance.

Tom A. Lewis, Chief Executive Officer of Realty Income commented, “We are pleased that our operations allow us to once again increase the amount of the dividend we pay to our shareholders. With the payment of the January dividend, we will have made 510 consecutive monthly dividend payments.”

“We have generated record results for each of the past five years and believe 2013 will be another record year,” said Truman Hunt, president and chief executive officer. “Based on our consistent growth and our commitment to return capital to stockholders, we expect to increase our 2013 dividend by 50 percent, which would represent a 140 percent increase in dividends over the past three years. With our strong performance and increasing cash flow, we have the financial flexibility to increase dividends, repurchase shares and continue to invest in important business initiatives to sustain revenue growth.”

Beginning with its regular first quarter dividend in 2013, the company currently expects to pay a quarterly dividend of $0.30 per share, or $1.20 per year, compared to the previous quarterly dividend of $0.20 per share, or $0.80 per year.

“We are pleased that the strength of our financial position allows us to increase our dividend payout to shareholders,” said Mark E. Speese, Chairman and Chief Executive Officer of the Company. “This dividend increase reflects not only our confidence in the Company’s strong cash flows, but also our belief that continued investments in our strategic initiatives will generate further growth and provide long-term value for our stockholders. While we continue to focus on both international and RAC Acceptance kiosk expansion, it is our intent to continue returning value to shareholders through increased dividends every year,” Mr. Speese concluded.

“The dividend increase is a testament to our continued commitment to returning capital to shareholders and demonstrates our continued confidence in the business,” stated Ian Read, Pfizer chairman and chief executive officer. “We remain focused on total return to shareholders, of which the dividend is a key component.”

The dividend increase will result in a quarterly dividend of thirty-five cents ($0.35) per share on the $0.10 par value Common Stock of the       corporation for an indicative 2013 full-year dividend of $1.40 per share, subject to the normal quarterly review by the Board. The next quarterly dividend will be payable on February 1, 2013, to stockholders of record at the close of business on January 4, 2013.

On December 31, 2012, all of the Bush-era tax cuts are set to expire, including the very favorable 15% tax rate on qualified dividends. With no action between now and then, the top tax rate on dividends will nearly triple to 43.4%. Note: If the tax cuts expire, dividend income will be taxed as ordinary income.

According to the most recent IRS data, more than 63% of taxpayers with qualified dividend income are 50 and older.  For those on fixed incomes and counting on dividends to help pay their bills, having to pay higher taxes could be devastating.

We think that the dividend tax cuts will ultimately be extended (albeit at slightly higher levels), since it would be political suicide to allow the dividend tax rate to revert back to ordinary income levels at this point. That said, we also think that investors should hope for the best, but plan for the worst.

What Will A Dividend Tax Hike Mean To You?

If you are relying on dividend income to pay your bills, it’s unlikely that you are in the highest tax bracket. However, there is a good chance that you would fall into the 28% or 31% brackets, which would essentially double your tax rate on your dividends.

While a dividend tax hike would be an unfortunate reality for income investors, it certainly shouldn’t cause a mass exodus from dividend stocks. The Fed has essentially guaranteed that interest rates will remain near zero percent until at least 2015 and good risk-adjusted yield will continue to be hard to come by. In our opinion, dividend stocks will remain one of the best income-generating options for investors for the foreseeable future (tax hike or not).  Investor should also remember that dividend tax rates are currently low by historical standards.

Obviously, investors have no control over what Washington decides to do regarding future tax rates. However, we feel that DIY Investors should stay the course with their dividend investment plan. Your after tax income may end up being slightly lower, but there are limited alternatives out there for good risk-adjusted yield. In addition, we also recommend that investors implement conservative option strategies (like covered calls and cash-secured puts) to augment future income. Note: We are currently implementing these option strategies in our Model DIY Dividend Portfolio.

Institutions Will Support Valuations

Retirees are not the only investors that hold high-quality dividend stocks. As is the case with most stocks, institutions (like mutual funds and pension funds) are typically the largest holders of dividend stocks. That said, institutions tend to have long-term investment strategies that are based on fundamentals (not on changes in investor tax rates).

In the worst case scenario highlighted above (if all Bush-era tax cuts expire), there will likely be a short-term sell-off in dividend stocks. However, in our opinion, a tax hike-driven pullback will be a HUGE buying opportunity for long-term dividend investors. Individual tax rates should have a minimal effect on stock valuations and we believe that institutions will also see any pullback as a prime opportunity to add to their positions.

Strategy: Keep Your Watchlist Handy and Buy Good Stocks On The Dip

Note: The stock screen above was derived from the monthly ratings spreadsheet that we post for Premium Subscribers each month.

As we discussed above, we think that any pullback in dividend stocks due to a tax hike will be short-lived. It’s important to keep a watchlist of stocks that you would like to own handy during a pullback, because this is the perfect time to build a long-term position (especially if you have a hedge in place as well). Stocks screens are great way to build your watchlist.

The screen above looks at high-rated dividend stocks that high institutional ownership. All else being equal, stocks with high institutional ownership will likely be less volatile that stocks with lower institutional ownership. Investors may want to consider purchasing some of these stocks on further weakness.  Below are the full parameters for the screen:

• Current Price > $10.00
• 50-day Avg. Volume > 1,000,000
• Dividend Yield > 3.0%
• Parsimony Rating > 80
• Beta < 0.75
• Institutional Ownership % > 60.0%

Disclaimer: A screen like this should be only used as the starting point of your analysis. Just because a stock has high institutional ownership, it doesn’t mean that it is a good buy currently. For those of you that are interested, we send out a weekly watchlist to PREMIUM Subscribers with actionable “Buy Zones” for each stock (which we believe are low risk entry points).

Market corrections happen. As a matter of fact, we would add market corrections to the list of things in life that are guaranteed. Just like death and taxes, market corrections are a way of life.

Over the past 15 years, the market has corrected at least 10% (from peak to trough) 8 times. In addtion, in between those 8 major corrections, there were another 17 pullbacks (of at least 10%) within those major corrections.

What is this data is telling us? It tells us that we need to EXPECT, and more importantly, PLAN for major corrections.

How Do You Plan For A Market Correction?

Investors can plan for a market correction by taking the necessary steps to hedge their portfolio. In our opinion, a protective put hedge strategy is the easiest and most cost-effective way to hedge a portfolio. Investors could also raise cash by selling some positions.that have run up significantly.

We started to warn investors back in August to tread with caution when the market was flirting with 4-year highs. As shown in the chart above, the Relative Strenth Index (RSI) was giving an overbought signal in early September. Then, in early October, the market failed to make a new high…and it has been downhill ever since.

In early September, we decided to purchase a protective put for the model DIY Dividend Portfolio based on the signals that we discussed above.

Hedging With A Protective Put

The main purpose of hedging your portfolio is to limit your downside market exposure (i.e., protect your capital base), while keeping your dividend income intact. As we said above, we believe that purchasing a protective put is the easiest (and most cost effective) way to hedge your portfolio. Note: If you are unfamiliar with options, there are some great free websites out there to educate yourself (like the Option Industry Council).

We like to use options on the S&P 500 ETF (SPY) for our protective put strategy. We are only trying to “hedge” the general market exposure in our portfolio and the S&P 500 is a great proxy for the general market. In addition, SPY options are extremely liquid, which makes them very easy to trade.

There are two main decisions that you have to make when implementing a protective put strategy: (1) choosing the strike price and term of the option and (2) deciding how many options to purchase.

• Strike Price/Term - In general, we prefer shorter term options (less than 3 months until expiration) over longer term options and we prefer “in-the-money” options over “out-of-the-money” options. We have these preferences because we try to limit the ”time value” exposure in our protective put. For example, with SPY currently trading around $139.00, we would probably focus on the Jan 2012 $144 or $145 strikes.
• Number of Options (Size) - Every portfolio is different, but the weighted average Beta of your portfolio is a good metric to use to estimate your portolio’s general market exposure (i.e., systematic risk). For example, if your portfolio Beta is 0.50, the volatility of your portfolio should theoretically only be half that of the general market (i.e., if the market declines 1%, your portfolio should only decrease 0.5%). Note: We have a FREE spreadsheet on our website that will help you calculate the weighted average beta of your portfolio as well as the number of put options you need to implement your hedge.

No hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market.  Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge.  Whether or not you decide to hedge your own DIY Dividend Portfolio will depend on your specific market outlook and risk tolerance.

Keep Your Watchlist Handy and Buy Good Stocks On The Dip

Note: The stock screen above was derived from the monthly ratings spreadsheet that we post for Premium Subscribers each month.

It’s important to keep a watchlist of stocks that you would like to own handy during a market correction, because this is the perfect time to build a long-term position (especially if you have a hedge in place as well). Stocks screens are great way to build your watchlist.

The screen above looks at high-rated dividend stocks that are currently at least 12% off of their 52-week high.  Investors may want to consider purchasing some of these stocks on further weakness.  Below are the full parameters for the screen:

• Curent Price > $10.00
• 50-day Avg. Volume > 200,000
• Dividend Yield > 3.0%
• Parsimony Rating > 80
• % Off 52-Week High > -12.0%

Disclaimer: A screen like this should be only used as the starting point of your analysis. Just because a stock has sold off, it doesn’t mean that it is a good buy currently. For those of you that are interested, we send out a weekly watchlist to PREMIUM Subscribers with actionable “Buy Zones” for each stock (which we believe are low risk entry points).

This represents the 30th quarterly distribution increase for the Partnership.

McDonald’s Chief Executive Officer Don Thompson said, “Today’s announced dividend increase brings our 2012 expected total cash return to shareholders to at least $5.5 billion through dividends and share repurchases.”

Thompson continued, “McDonald’s commitment to enhancing the customer experience – from our menu and operations to our value and convenience – continues to move us closer to becoming our customers’ favorite place and way to eat and drink.  Our philosophy on the use of capital remains unchanged with our first priority being to reinvest in our business to drive sales and cash flow, while generating strong returns.  After these investment opportunities, we expect to return all of our free cash flow to shareholders over the long-term through dividends and share repurchases.  Today’s dividend increase demonstrates our confidence in the long-term strength of our Brand and our commitment to enhancing shareholder value.”

McDonald’s has raised its dividend each and every year since paying its first dividend in 1976. The new quarterly dividend of $0.77 per share is equivalent to $3.08 annually.