Many investors are familiar with the largest listed investment company (LIC) on the ASX, Australian Foundation Investment Company [ASX:AFI].
Founded in 1928, the $6.7 billion AFIC has built a reputation for delivering its shareholders a reliable stream of fully franked dividends. In its near 90-year history, only four people have chaired the company.
If you’re not familiar with LICs, they are similar to a managed fund. LICs invest in a range of companies on the ASX. By investing in an LIC, shareholders gain access to a broad range of companies through the one holding.
Because LICs are listed, investors can trade in and out of them the same way as they would with any other share. It’s much simpler than redeeming funds from a conventional fund.
AFIC’s shareholdings include some of the most blue-chip companies on the ASX. Many of these it has owned for decades.
Its largest holding is its $630 million position in Commonwealth Bank [ASX:CBA]. Plus there’s others you’ll know just as well — companies like Woolworths [ASX:WOW], Telstra [ASX:TLS] and Transurban [ASX:TCL]. All up, AFIC has around $4.7 billion spread across its top 25 holdings.
AFIC chooses these companies based on their strength and stability. Plus, their steady flow of franked dividends. What investors might be less familiar with is, though, is that AFIC doesn’t rely only on dividends to generate income.
Another stream of income
Each month, LICs provide an update on their current holdings. It will typically show their top 25 holdings, plus the size of their holdings in each one.
But if you take a look at AFIC’s most recent update (for May 2017), you’ll see something a little bit different to other LICs. Among AFIC’s top 25 holdings, you’ll see an asterisk against eight of them.
These asterisks represent those shares in which it has an option position. Or in other words, shares over which it has written call options. AFIC has written call options over roughly one-third of its top 25 holdings.
It doesn’t mean that AFIC has written options over the entire positions of each of these stocks. Rather, that it has written options over a portion of each of these holdings. As of its most recent update, three of these eight include option positions on National Australia Bank [ASX:NAB], Brambles [ASX:BXB] and QBE Insurance [ASX:QBE].
But why does AFIC do this?
The reason is to generate additional income beyond dividends. By writing (selling) a call option over a shareholding, it enables the option writer to collect a premium. But how does it work?
Converting time into money
If you’re new to options, they can be a little bit confusing. There are plenty of fancy strategies with equally elaborate names. But all options strategies are derived from two basic option types — call and put options.
Call options give the buyer the right to buy the underlying shares at any time until the option expires. A put option gives the buyer the right to sell the underlying shares at any time until the option expires.
It’s the first of these — a call option — that AFIC uses to generate income.
For someone to buy a call option, there needs to be someone willing to take the other side of the trade. That is, an option writer. For writing an option, you collect a premium. However, in writing an option, you’re taking on an obligation.
The obligation is that by writing a call option, you must hand over the shares — at the option strike price — if the buyer exercises their option. If you write a call option on Telstra at $4.50, for example, you must hand over Telstra shares at that price (if the option is exercised).
By writing an option, your aim is to take advantage of something inherent to all options — time decay.
All options have a finite life. Once they reach expiry, and haven’t been exercised, they cease to have any value. By writing a call option, your aim is to convert this time decay into cash.
Some basic rules
There are a number of things you need to consider, though, before writing call options. Firstly, that you’re prepared to hand over the shares if the buyer exercises the option.
That means that you only write a call option at a strike price (the price at which the shares are exchanged) that you’d be prepared to sell the underlying shares.
The higher the strike price you write a call option at, the less chance it has of being exercised. But…the less premium you’ll receive. It’s a trade-off between the two.
You also want to be sure that you’re receiving enough premium for the obligation you’re taking on. There’s little point in writing a call option if you don’t generate sufficient premium.
You also want to avoid writing a call option near an ex-dividend date. If the buyer exercises the option before an ex-dividend date, you will still have to hand over your shares, and miss out on the upcoming dividend.
But the other thing you also need to think about is tax. If you write a call option, and it’s exercised, it settles like any other share trade. That means that if you’ve made a profit on the sale of the shares, you might be liable for capital gains tax.
Writing options is one of the strategies we use at my advisory service, Options Trader. It can be a great way to generate extra income on top of dividends.
However, you should only write call options if you think the share price is going to trade sideways, or slightly down — not if you think the share price is going to tank. While writing a call option will generate premium, it won’t be sufficient to offset any major fall in the underlying stock.
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