With dividend income falling, what’s the alternative?
With dividend income falling, what’s the alternative?
Australian investors are faced with significant reductions in dividends as blue-chip stocks defer or cancel their dividends. The economic impact and ongoing uncertainty presented by COVID-19 has even seen the Australian Prudential Regulation Authority encourage banks to reduce their shareholder payments.
If you rely on income generating assets, trading in exchange-traded call options may be a viable alternative.
A covered call strategy, for example, can generate income in the form of a call premium in a flat or gradually rising market, while cushioning losses in a falling one.
Here’s how it works
If you own shares you believe will move sideways or slightly up, you can elect to sell a ‘call option’. This is a commitment to sell shares for a price you choose (the strike price) on a date you choose (the expiry date). This commitment earns you income, typically called a premium.
If the share trades below the strike price on the expiry date, then you keep the premium and may continue to hold the share.
The following month you can choose to sell another call with a new strike price and expiry date. This can continue as long as it suits your strategy.
In the US, the put/call ratio has recently been at its lowest level for six years. This ratio of puts (bear focused trades) to calls (bull focused trades) can indicate the direction investors think the market is going. So what exactly makes a covered call strategy so popular? Let’s investigate by way of a simplified case study.
Mark buys 1000 shares in Company A through his margin loan, which is trading at $76.50. This gives him a total investment value of $76,500.
Mark decides that he is prepared to sell his shares in Company A at $80. He sells a call with a strike price of $80, which expires in 30 days. In return for this commitment he receives a credit of $0.70 per share, a total of $700 for the 1000 units held.
If Company A is trading above $80 at expiry Mark will most likely need to give up his shares at $80. If the stock is trading below $80, the sold call will expire worthless and he can choose to sell a new call at a new strike price.
Factors to keep in mind
If Company A trades above $80 on any day before the expiry date, his shares may not be called upon, which means he will continue to hold them. It is up to the buyer of the call whether the call is exercised. (The option is often automatically exercised if it is trading above $80 after the expiry date.)
Mark could also sell a call for a period longer than one month if he didn’t want to actively trade this portfolio which would also provide him with a larger credit.
What if the share remains flat or increases gradually?
Let’s assume the share closes anywhere between $76.51 and $79.99 on expiry. This is the ideal scenario, because Mark is profiting from his underlying position in Company A as well having the sold call expire worthless. Mark will keep the $700 premium with no further obligation to the sold call. (In a flat market, covered calls tend to outperform a long only portfolio.)
What if the share increases in value dramatically?
If the share increases to $82 at the option’s expiry, Mark will most likely need to sell the share at his chosen strike price of $80. He will have still profited from the trade, keeping the $3.50 profit from the share, which increased from $76.50 to $80.
While Mark will also keep the $700 premium from the sold call (along with any other dividends or franking credits he may be entitled to) he won’t benefit from any further increase in the share price above $80. (In a quickly rising market, coved calls tend to underperform a long only portfolio.)
What if the share declines in value?
Let’s assume that, at expiry, the shares for Company A are trading at $72.00. Given that Mark purchased at $76.50, he’ll be down $4.50 per share ($4,500 in total) if he doesn’t sell the call. If he instead sold the call and received a $700 credit, his loss would be reduced to $3800 ($4500 loss in the share less the $700 credit from the sold call premium).
While this is still a loss, he is still in a better position than if he had not sold the call at all.
If Mark had been receiving a number of credits from the months prior his net loss would be even less. In a falling market covered calls tend to outperform a long only portfolio.
Could this strategy be right for you?
Historically, covered calls have been shown to produce more consistent returns in a flat, slowly rising or even a falling market but tend to underperform in a quickly rising market.
For advice on this approach, please consult your financial advice specialist.
If you have any questions or would like to discuss how exchange-traded options can be combined with your Leveraged margin loan, please get in touch with your financial adviser, your Leveraged Relationship Manager, or contact us on 1300 307 807.
Things you should know
Gearing involves risk. It can magnify your returns; however, it may also magnify your losses. Issued by Leveraged Equities Limited (ABN 26 051 629 282 AFSL 360118) as Lender and as a subsidiary of Bendigo and Adelaide Bank Limited (ABN 11 068 049 178 AFSL 237879). Information is general advice only and does not take into account your personal objectives, financial situation or needs. The views of the author may not represent the views of the broader Bendigo and Adelaide Bank Group of companies (“the Group”). This information must not be relied upon as a substitute for financial planning, legal, tax or other professional advice. You should consider whether or not the product is appropriate for you, read the relevant PDS and product guide available at www.leveraged.com.au, and consider seeking professional investment advice. Not suitable for a self-managed superannuation fund.
Examples are for illustration only and are not intended as recommendations and may not reflect actual outcomes. Past performance is not an indication of future performance. The information provided in this document has not been verified and may be subject to change. It is given in good faith and has been derived from sources believed to be accurate. Accordingly no representation or warranty, express or implied is made as to the fairness, accuracy, completeness or correction of the information and opinions contained in this article. To the maximum extent permitted by law, no entity in the Group, its agents or officers shall be liable for any loss or damage arising from the reliance upon, or use of the information contained in this article.