The Dividend Champions portfolio focuses on companies that will generate and grow wealth over the long term. So it’s mainly “buy and hold.” However, you can create additional income on your holdings, protect against downside risks and enhance the returns on long positions with simple options strategies.

Starting this month, on a trial basis, we will include option plays to supplement our core strategies.

This is not intended as a full options trading service. Instead, we will provide ideas for investors who are comfortable with options trading. If you wish to learn more about options trading, please follow this link to this guide (particularly sections one and three) that explains the basics of options trading.

In addition, U.S.-based investors should note that some of the options can only be traded on the Canadian markets. Please consult your broker if you have questions about gaining access to Canadian options.

We intend to use low-risk strategies focused on three main categories, which we discuss below. Experienced option traders may want to create more sophisticated strategies based on the underlying investment ideas.

Category 1: Additional Income.

This strategy will generate additional income on long equity positions and will typically take the format of a covered call. A covered call entails selling a call option against shares you hold in a company.

We will normally propose this strategy when a stock becomes fully valued or overvalued with limited upside potential. By selling the call, further upside from holding the stock will be capped, but an option premium will earn you extra income on the long position.

The risk with this strategy is that the share price may keep going up and that the shares may be called away, forcing you to sell your shares.  So you would lose the additional capital gain above the strike price (the price at which the call option can be exercised). However, there are ways to manage this risk — we refer you to this excellent writeup on the Schwab website.

Let’s take a look at how this would look in practice with a hypothetical example. (Note that no trading costs are factored in this or the other examples below.)

Thesis: We believe that company ABC’s share price (let’s say currently at $C75 per share) may be going nowhere for some time, as the valuation is full and the growth outlook is anemic. In addition, the stock has a low dividend yield of only 1.5%, and you can get additional income by selling a call.

Option Strategy: Sell a covered call option with a strike price of C$80 and an expiration date of Sept. 16, 2016. Assume the price of the stock at this point is C$75 and the option price is C$1.00. A call option typically covers 100 shares. So you’ll receive a C$100 premium (C$1.00 x 100).

In addition to the option premium, you will most likely also earn the dividend (one dividend of C$0.28 per share) before the option expires on Sept. 16, plus any capital appreciation up to the call strike price.

Outcomes: If all goes according to plan (i.e. the share price stays below C$80), the option will expire worthless on 16 September, the income yield will be enhanced to 1.7% over the 105 days holding period (which is the equivalent of 6.1% annualized compared to the 1.5% dividend yield received on holding the stock only). In addition, the strategy will allow for a capital gain of up to 6.7% for a total maximum return of 8.4% until the expiry of the option. This strategy could be repeated multiple times over subsequent quarters to enhance the yield on the stock until such time that we feel the share price is ready to advance. Note that the covered call position provides a better outcome than holding only the stock unless the share price appreciates meaningfully.

Category 2: Downside Protection

We will use this strategy if we are concerned that a critical risk factor may materialise over the holding period causing a decline in the share price. This can be done against holding a long equity position (protective put) or without a long position (speculative).

Again, let’s use a hypothetical to illustrate how this strategy would play out.

Thesis: We are concerned about the downside risk created for bank DEF by the bubble that has developed in the Vancouver and Toronto housing markets. Assume the current share price is C$80.

Option Strategy: Buy a protective put option that expires on Jan. 20, 2017, with a strike price of C$72, 10% below the current spot price. This will cost C$240 per option (100×2.40).

Outcomes: For investors long of the shares, the put option will provide downside protection with a maximum loss of 11% from the current price, including the quarterly dividend (C$0.81/share per quarter). This compares to potentially a considerably larger loss for investors only holding the shares if the Canadian housing market takes a tumble.

Investors who don’t own the stock and who just wish to buy the put option can profit considerably if the stock price moves below the strike price before the option expires. Should the share price, for example decline to C$65 from the current level before the option expires in January 2017, holders of the put option will gain 192% on their original investment. The downside risk is limited to a loss of the option premium.

Category 3: Upside Enhancement

We will use this strategy when we suspect that a share price has considerable upside potential from current levels. The built-in leverage of options can increase profits while the downside is limited to what you pay for the option.

Thesis: We think there is good upside potential in the share price of company GHI should any of a number of large contract bids come to fruition over the next few months. Assume the price is C$30.

Option Strategy: Buy a strike C$30 call option with an expiration date of Oct. 21, 2016 for C$230 per option (C$2.30×100).

Outcomes: The call option has unlimited upside potential should the share price move over C$32.30 (that is the strike price plus option premium) before the expiration date. Say, for example, that some of the contracts are awarded to the company and the price spikes to C$35 by the time of expiry, then the profit will be C$270 per option (2.70×100) or 117% on the capital outlay. The profit on holding the shares only would be 17%.

We hope that you will find the options strategies useful and interesting as a value added service to the Canadian Edge. Please let us know what you think through the Stock Talk  section on the website.