Most of us are familiar with the concept of income (or dividend) investing. It’s a basic strategy where investors buy shares in companies that pay out dividends to their shareholders.
The more consistent a stock’s income stream is, and the more its dividends grow (sustainably), the higher the value the market will put on it. You only need to see the growth in dividend payouts by the big banks over the last couple of decades to see how this has flowed through to their share prices.
Income investing is most often associated with older and more mature businesses. That is, companies that have been around for a long time and are well established. ‘Growth’ companies will usually need to hold onto their cash to help fund their growing business.
While dividend investing is a popular strategy, it’s not the only way to generate income from the markets. For a start, most dividend-paying stocks only pay out distributions twice a year. That’s a long time to wait in between payouts.
And it requires a decent chunk of capital. The market yield (the average across the market) is currently 4.3%. That’s nearly double what you’ll get on a term deposit; but to earn $4,300 a year, an investor would need to invest $100,000. Of course, franking credits can increase this return, depending on the investor’s tax bracket.
Another way to increase the returns on shares is by writing (selling) call options over them. It’s a strategy used by one of the ETFs in Total Income, my income advisory service. This particular ETF is the BetaShares Equity Yield Maximiser Fund [ASX:YMAX], which currently trades on a yield over 10%, with distributions paid quarterly.
YMAX holds shares in each of the companies in the ASX 20, and generates income from two sources: collecting dividends, and writing (or selling) call options over these holdings.
Options often get put in the ‘too hard’ basket by a lot of investors. Not least because of all the jargon that comes with options. But by showing a basic example, I hope it helps to make using options a bit clearer. Please note the following is not a recommendation.
An Example on How to Generate Income with Shares
Let’s say an investor did their analysis and decided they wanted to buy shares in Westpac [ASX:WBC]. The next dividend is due to be paid in December, with the ex-dividend date in November.
To qualify for the dividend, a shareholder needs to have bought shares in Westpac (and still own them) prior to the ex-dividend date. The ex-dividend date is the first day of trading in which the shares don’t come with any entitlement to the upcoming dividend.
If this investor wanted to generate income from their Westpac shares before the dividend, one way would be to sell some call options over them.
At time of writing, Westpac is trading at $30.35. If the investor bought shares at that price, they could hold on until the ex-dividend date in November to collect the dividend. In the meantime, though, they could sell call options over Westpac to generate more income.
Let’s take a look at the following table:
[Click to enlarge]
I’ve put a red box around the Westpac call options with a strike price of $30.50. The option is bid at $1.265 and offered at $1.38, so the option would likely trade at around $1.32.
The investor could buy shares in Westpac at $30.35, while selling a call option (that expires in October) with a strike price of $30.50, and receive $1.32 in premium.
Option contracts are typically for 100 shares, so, with this strategy, the investor would buy 100 shares in Westpac, while selling one option contract, which would generate $132 (before brokerage) in income for each contract written. Of course, the investor could trade a bigger amount, like buying 1,000 shares and selling 10 option contracts if they wished.
This is called a buy/write strategy, but what does that mean?
By writing the call option, the investor is agreeing to hand over their shares at $30.50, if the option buyer exercises the option. All options have expiries, so the option buyer has until Thursday, 27 October to exercise the option (in this example), before it expires.
It’s also important to note that there are two different option styles — american (where an option can be exercised at any time up until it expires), and a European style (which can only be exercised at expiry).
For taking on this obligation, the call option buyer pays the seller a premium. In this case, that would be around $1.32. You can see, though, that the call option seller is giving up potential profit (and dividend) if the option is exercised.
Let’s say that Westpac is trading at $35 when the option expired; they’d still have to hand over the shares at the strike price, which is $30.50 in this example. And they’d miss out on the dividend — you need to be careful not to write call options that expire too close to ex-dividend dates.
If you take another look at the table, you’ll see higher strike prices as you work your way down. If you look on the left, you’ll also notice that the premiums decrease as the strike prices increase. The further away the strike price, the less chance the option has of being exercised. So, the option buyer will be prepared to pay less for the option.
If the share price trades sideways and closes below the strike price when the option expires, the option seller will keep their premium (and their Westpac shares). They could then look to pick up the dividend, and look to sell another lot of call options to generate more income.
It’s important to understand that writing the call option doesn’t protect the investor from a fall in the share price. The premium received would help dampen the loss, but the investor would still lose money if the Westpac share price fell.
Another important thing to remember: Only write call options if you already own the underlying shares. To sell a call option (or more options than you have shares) without owning the shares could lead to unlimited losses, as technically a share price could go to infinity.
If someone wrote one call option contract on Westpac at $30.50 (and didn’t own Westpac shares), and the share price went to $40.50 and their option was exercised, they’d have to buy the shares on market at $40.50, and then sell them to the call option buyer at the strike price of $30.50 — a $1,000 loss for every contract written.
An investor would only implement a buy/write strategy if they were happy to own the shares, but didn’t think the share price was going to appreciate too much — that is, more than the premium received for writing the option.
Nor would an investor look to do it in a heavily falling market, as they could lose more on the shares than they might gain in premiums from writing the call options.
A buy/write strategy is best used in a range-bound market, or very slightly rising or falling market. That way, the investor can keep writing options to generate income, while trying to avoid being exercised or losing capital on their shares.
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