With a market yield almost double that of the MSCI World Index — the index representing the 23 developed markets in the world — Australian shareholders are well aware of the benefits of investing in stocks to generate income.
It’s something that has only been accentuated with interest rates at record lows.
But as Commonwealth Bank’s [ASX:CBA] results yesterday highlight, relying on the growth of dividends might also be harder to come by. For the first time since 2009, CBA was unable to increase its final dividend — something it has achieved for most of its 25 years as a public company.
The trouble facing a lot of companies is easy to define, but hard to fix. That is, the challenge is to grow profits — and increase dividend payouts — when revenue growth is fickle. The other way is to cut costs, but that has its limitations too.
For investors relying on dividends, any cut back or flattening of dividends isn’t the kind of news they want to hear. Especially when their dividends only arrive twice a year.
However, there’s a strategy that can help increase the income available from a stock. And it’s something we’ve used at Options Trader, which the following trade illustrates.
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Harvesting income from stocks
In October last year, Options Trader members did a buy/write trade on Telstra [ASX:TLS]. A buy/write trade involves buying shares — in this case Telstra — while selling (also called ‘writing’) call options over them. By selling these call options, they received a premium (income) from the option buyer.
Options have a finite life. An option that expires without being exercised has no value, and the premium is the option writer’s to keep.
However, writing an option isn’t just a one way street. The call option writer takes on an obligation, which is to hand over the shares at the option strike (or exercise) price, if the option is exercised.
To see this in action, let’s run through the Telstra trade now.
The original trade was to buy Telstra shares at market, which, at the time, went through at $5.53 (15 October 2015). Members bought 1,000 shares, and sold 10 Telstra call options (note: each option contract is normally for 100 shares) for a premium of 20 cents per contract, or, $200 before brokerage.
The call options had a strike price of $5.50 and a December expiry. Telstra shares closed at $5.44 on the day of the option expiry (Thursday, 17 December), leaving the options to expire worthless — and with that, the option premium in the bank.
The next part of the strategy was to collect the dividend. Telstra went ex-dividend on 1 March 2016 for 15.5 cents per share. That generated $155 on the 1,000 shares for the trade.
But rather than waiting six months for the next dividend, we wanted to look for more income. We then wrote another call option on 20 April. This was for 10 call options (again, 100 shares per contract) with a $5.40 strike price and a June expiry which generated $160 in premium, before brokerage.
This time, Telstra closed at $5.34 on the day of the option expiry (Thursday, 23 June), six cents below the strike price, leaving the option to expire worthless — and, again, the option premium in the bank.
We then wrote a third lot of call options, this time on 20 July, at a strike price of $5.75 and an October expiry. This generated $140 in premium, before brokerage, and is still currently open.
The aim of this recent trade was a double hit. First, to generate premium income by writing the option. The other is to collect the upcoming full-year dividend. Telstra trades ex-dividend on Wednesday, 24 August. Unless the option is exercised by the buyer prior to that, we’ll be entitled to pick up the full-year dividend as well.
This open option trade expires on Thursday, 27 October. If Telstra is trading at the $5.75 strike price or higher, we can expect the option to be exercised. We’ll be obligated to hand over the Telstra shares at $5.75, even if Telstra shares are trading much higher.
But like the first two call option trades we did, if this option isn’t exercised, once again the premium will stay in the bank, and we’ll look to write more call options. And then the aim is to collect the interim dividend, when Telstra goes ex-dividend sometime in late-February next year.
Twice the income of just buying shares
If we’d just bought the shares in October, we’d be looking forward to the upcoming dividend. That would give two lots of dividends for the year. But by doing a buy/write strategy, we’ve picked up three lots of option income, plus the interim dividend. And we’ll get the full-year dividend as well, if our October call option isn’t exercised by 24 August.
You can see that these option trades have more than doubled the income on Telstra for the year. But it’s also important to understand the risks and limitations of the strategy.
For a start, selling a call option doesn’t protect the underlying shares, should the market take a tumble. The income generated from writing the option might cushion the fall, but you’re still exposed to a fall in the share price — the same as if you just bought the shares outright.
And writing a call option caps potential upside. It locks in a sale at the strike price, even if the shares are trading much higher. Although, the option writer can look to buy the options back before they expire.
Looking for both share price and dividend growth is becoming increasingly difficult in the current market. But one way to boost income is to make stocks work harder — something which can be achieved through a buy/write strategy. The goal is to harvest stocks for as much income as we can.
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