With term deposits barely paying a pittance, swags of investors have had to increase their exposure to dividend-paying shares to supplement their income. However, the risk of this strategy is pretty obvious. The more money you have tied up in shares, the more capital you risk whenever the market takes a tumble.
Instead of putting extra money into the market, though, one solution is to make your existing portfolio work harder…but how do you go about it?
If you own any of the larger companies on the ASX, you’ll already be quite familiar with collecting dividends to generate income. However, with most of these companies only paying dividends twice a year — and six months apart — that’s a long time to keep your money tied up while you wait for the next payment to hit your account.
One way you can generate extra income in between dividends is to write (or sell) call options over your existing shares. This strategy, known as a ‘covered call’, is a popular way to make your portfolio work harder for you.
And the good news is that you don’t have to put any extra money into the market to do it. You are writing call options over your existing holdings, to generate additional income beyond the usual dividend payments.
An option that expires without being exercised ceases to have any value. So the call option writer gets to keep the premium they received for writing the option, and repeat the process over. If they are exercised, though, the call option writer must hand over the underlying shares at the strike price.
There’s always a trade-off, though, when you write a call option. The closer the strike price is to the current share price, the more premium the option writer is likely to receive. However, the higher the chance that the option could get exercised.
And as you’d expect, the further away the strike price, the less likely the option will get exercised. But…the lower the premium the option writer is likely to receive. By the time you pay brokerage, it might hardly be worth the effort.
All options have strike prices; and all options have expiries. So you need to think about how far you think the share price might move before the option expires.
There’s also the factor of time to consider. The further out the expiry is, the more time the share price has to reach the strike price. So again, the more premium the option writer will want to receive.
The idea is that you only write a call option at a strike price you’d be prepared to hand the shares over at, if the option is exercised. A further proviso is that you also earn sufficient premium.
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A covered call in action
For example, (note: this is not a recommendation) let’s say AMP [ASX:AMP] is trading at $5.75 and a call option with a strike price of $6 (and three months until expiry) is trading at 18 cents. With typically 100 shares per option contract, a call option writer would receive $180 premium on 10 contracts (1,000 shares). Not forgetting brokerage, you’re likely to pay around $35 for an online option trade.
By way of comparison, if the current dividend is 15 cents for example, an AMP investor with 1,000 shares would receive $150. By writing call options twice throughout the year, and collecting these dividends, you could potentially double your income from the one stock.
When to write a call option
When you write a call option, you are obligated to hand over the underlying shares, if the option is exercised. Brokers will usually exercise any options that are in the money at expiry, which in the case of a call option, means that the share price is trading above the strike price.
So using the above AMP example, you’d expect the $6 call option to be exercised if the share price was trading at this price or higher at expiry.
While writing a call option can be a handy way to top up your income, you’ve also need to know when to write them. For example, writing a call option is a rising market can lead to frustration and missed profits.
First, while you might lock in some capital gain (and income from the option premium), you could be giving up a much bigger capital gain if the share price goes for a big run up.
The best time to write a call option is in a flat range-bound market, or a falling market. But you need to be careful with the latter scenario. If the share price was to drop quickly, you could lose much more in capital than you might generate in premium income.
Another thing you need to be careful of is upcoming dividends. Even in a flat or falling market, the share price can get bid up by investors wanting to participate in any distributions. While you can generate income from writing a call option, you want to avoid being exercised by an investor who wants to qualify for the dividend.
That’s why you would try to avoid writing a call option with an expiry close to the ex-dividend date. Conveniently for option writers, though, one way to avoid this is to use a different style of option.
American-style options can be exercised at any time until the option expires. European-style options, though, can only be exercised on the day of expiry. By writing a European-style option, you can avoid the early exercise of a call option by a buyer wanting to participate in the next dividend.
How to start
A covered call is one of the more basic option strategies. So if you’re new to options, you shouldn’t need to set up an advanced options account — just a basic one should do.
The good thing is that you can tiptoe your way into the market — you don’t need to come out with all guns blazing. One way to start is by writing call options over a portion of your shares. So if you owned 2,000 shares in AMP, for example, you might choose to start by writing call options over 200–300 shares. That’s two to three contracts.
And you always need to be aware of the tax implications. If you write a call option and it gets exercised, it’s settled as per any normal share transaction. That’s T+2 with the new ASX settlement cycle. If you’ve owned shares for a long period and are sitting on a capital gain, you might be liable for capital gains tax from the proceeds.
If you’re nervous about writing call options on shares, you can write options on the ASX 200 index instead. Like a share option, you can usually carry this out through online brokers, once you set up an options account.
Writing options can be a handy way to spruce up the return from an existing portfolio, without having to allocate extra funds into the market. Just always be aware of your obligations — if exercised, you need to hand the shares over, even if the share price is trading higher than the strike price.
Editor, Total Income
Ed note: The above article was originally published in Money Morning.