International investors tend to look at the Australian stock market with a very narrow view. Up until the broad decline in commodities prices, foreign investors predominantly saw the ASX as a resources-dominated market. But they also viewed it as one based on yield.
That’s why money continued to flow into the ASX when most international markets were floundering. As their markets continued to stumble, Australia was enjoying a once in a generation boom in commodities, particularly iron ore.
But, as that bubble came to an end, trying to find growth in our market became difficult. So the focus turned to yield — something our market has been a leader in. And if you look at the makeup of the ASX 200 index, it’s not hard to see why yield-hungry investors flocked to our market.
The Australian market is very much skewed towards financial services. This sector accounts for around 40% of the entire index weighting. Led by the banks, this sector has consistently pumped out 5–6% yields — much of it fully franked — at a time when interest rates around the world plunged towards zero.
But while bank shares have appreciated greatly in value, trying to maintain any growth from here is looking extremely difficult. A lack of growth is also putting pressure on yields, as the banks head into an era of not only higher capital requirements, but a potential rise in bad debts (off historic lows) as well.
For income hungry investors relying on these yields, the choices are becoming a bit thin on the ground.
For investors looking to supplement this dividend income, one possible solution is writing call options over their shares.
What does that mean?
How options work
There are two types of options — a call option and a put option. An investor might buy a call option on a share if they thought the share price might go up. They pay a premium to the call option seller, who has to hand over their shares if the option is exercised.
An investor buys a put option if they think the share price is headed for a fall. They pay a premium to the put option seller who has to buy the shares if the buyer exercises the option.
Each option has a strike price. The strike price (also known as exercise price) is the price the shares change hands at if the option is exercised. For example, if an investor buys a call option with a strike price of $5, then they can buy the underlying shares at $5 at any time until the option expires.
If the shares are trading at $6 at expiry, then they still have the right to buy them at $5. The call option seller has to hand over the shares at $5, even though the share price in this example is higher — that is, $6.
You might be wondering why the call option seller would do this.
How you can benefit from selling options
Selling call options over shares is an income generating strategy. The option seller receives a payment for selling the option, called a premium. Often, this is a similar amount to a dividend payment. It’s not a strategy that protects the investor if the share price was to fall. The option seller can benefit investors, though, if two scenarios play out.
First, if the market trades sideways — there is no point in the option buyer exercising their option, because they could buy the shares at a lower price in the market.
Second, if the market falls — again, there is no point in the call option buyer exercising their option, as they also can buy the shares cheaper in the market.
To give you an example of how a call writing strategy works, let’s say you own 1,000 shares in a company trading at $5. Each option contract is typically for 100 shares. You sell 10 call option contracts with a strike price of $5.50 and receive 15 cents per share, per contract.
Before brokerage, typically around $35, you’d receive $150. That’s similar to what you might receive in dividends. If the share price closes above $5.50, then the option buyer will exercise their option and you have to hand over the shares.
If the share price stays below $5.50 at expiry, there is no reason for the option buyer to exercise the option. In this case, the option seller keeps the premium, and can look to sell another option over their shares.
However, one important consideration is tax. If you sell a call option over shares and get exercised, then it is no different to a normal share transaction. Meaning that you could be liable for capital gains tax if you make a profit on the shares. This becomes increasingly important if you’ve held the shares for a long time and are sitting on big capital gains.
Selling call options over shares doesn’t protect investors if the share price falls. However, it can be a great way to generate income, on top of regular dividends, especially when the markets are trading sideways, or drifting lower.
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For The Daily Reckoning