Dividend Trading -- what I learned this summer

What I learned this summer is that my dividend trading approach (buying stocks right before ex-dividend, and hedging by selling relatively deep in the money calls) works most of the time. Unfortunately it does not successfully handle the negative side of the "long tail" of market volatility. The long tail refers to the market's tendency to become much more volatile than normal at times--more often than the standard "normal" distribution would predict. I was caught with large positions in several stocks where the options were not assigned at the ex-dividend date (which is normally a good thing because I obtain the dividend with a good call option hedge), but then the overall market went into a nose-dive that ate up my 5% to 10% buffer on the stocks and promised significant loses if the stock continued to tank. I bailed out in both cases before my stock went out-of-the-money on the option, but I still took losses that will take a long time to recoup with the standard dividend trading sorts of returns. In both cases I would have been alright if I had held on, but one of my primary goals with dividend trading is to avoid the necessity to predict the direction a stock is going to go. This stress is something I don't need. Watching 2300 shares of the stock go up and down several points day (FCX) near my option strike price is not good for my blood pressure.

As always the market is very good at preventing free lunches and it requires significant risk taking to even have a reasonably priced lunch. I have spent some time looking for ways to avoid this risk, including stock futures, but so far I have not found anything that works to protect against the negative long tails without reducing the rate of return to CD levels. The opportunities that are still worth a look are the ones where the stock option expiration is only a few days after the ex-dividend date. Unless really dramatic things happen then the risk looks reasonable. The problem with these situations is that the premium available on the option is low, and the option is more likely to be assigned because there the premium available is low. The other thing I want to look at is whether the gains from the short option in a market sell off could be use to finance enough futures contracts to hedge the overall position successfully without killing the rate of return. One fairly promising approach would be to buy $VIX calls to hedge the negative long tail scenario. A quick look at the 2300 share FCX situation I held in July indicates that just a couple of $VIX $12.5 calls would have protected the position.