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 your clients are heavily reliant on income generating assets, trading in exchange-traded call options may be a viable alternative.

An options trading 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 your client owns shares they believe will move sideways or slightly up, they can elect to sell a ‘call option’. This is a commitment to sell their shares for a price they choose (the strike price) on a date they choose (the expiry date). This commitment earns them income, typically called a premium.

If the company’s shares trade below the strike price on the expiry date, then the investor keeps their premium and may continue to hold the share.

The following month the client can choose to sell another call with a new strike price and expiry date. This can continue as long as it suits the investor’s strategy.

In the US, the put/call ratio has recently been at its lowest level for six years. So what exactly makes a covered call strategy so popular? Let’s investigate by way of a simplified case study.

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 some of your clients?

As you know, it is one of several options trading approaches accredited derivatives advisers may suggest to clients.

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.

If you would like any further detail about how exchange-traded options can be combined with Leveraged margin loans, please contact your Leveraged Relationship Manager or call us on 1300 307 807.