The Pitfalls Of Creating Income Via An Options Strategy

By Tim McGowen | More Articles by Tim McGowen

Melbourne-based listed investment company Mirrabooka Investments recently announced a drop in earnings “due primarily to a reduced contribution from the Trading and Options Portfolios, which was $1.7 million this year compared with $3.1 million last year.”

As an ex-fund manager who executed on equity income portfolios it’s obvious that lower options income has come directly from a fall in market volatility. After all the premium an investor receives from selling options is primarily determined by market volatility, the more volatile the market, the more option premium a seller should receive. This strategy sounds simple enough and has been executed by sophisticated investors in the Australian market for decades. To many it’s known as a buy-write or equity income strategy, but if professional fund managers like Mirrabooka has seen their option-income almost halve, is it worthwhile creating income via an options strategy? Importantly how do you judge what is a sufficient yield to justify the strategy?

An enhanced yield.

Selling options against an equity position is like receiving extra dividends. To determine the yield of the position, an investor simply has to aggregate the dividends received plus the option premium earned (on an annualized basis). From a risk perspective I’ve always found it best to strip out the dividend and compare the option premium as a pure yield in isolation, this way you can determine whether the yield is adequate for the risk taken. After-all the strategy is exposed to equity-like risk. To compare the yield on a NAB equity income strategy for example, look at NAB bonds or preference shares as a lower risk yield comparison. You can determine the option yield of the strategy, like a dividend yield; simply annualize the option premium received to determine the equity income yield. If that yield is 4% per annum versus a NAB bond paying 6% I suggest the yield is insufficient for the risk assumed. This yield will change over time as markets become more volatile, so at some stage that yield will become attractive as a source of extra income.

Limited upside.

When volatility is low you will generally find you are in a favourable investment environment, so an investor needs to question the need to limit capital growth. This is because the payoff for an equity income strategy is that you cap the upside of an equity position in order to receive additional income. When I executed the strategy I usually sold the option about 5% above the current share price so I received some upside from the stock before the upside was capped. The option strike price plus the premium received determined the exit price of the shares. I executed on a quarterly basis as this 90-day period was when the option time decay was at its greatest.

Position management.

Whilst equity income is always promoted as a ‘set and forget’ strategy, I always found it was far from this in practice. The reality is that the most important factor over time is the cost price of the stock. If this strategy is to be executed successfully over time, then there has to be periods when options aren’t sold, as there is no point selling options to be put in a position where the stock is sold at a loss. Buying options back to avoid stocks being sold can also potentially produce income losses as well. So an investor has to have a clear understanding of the mechanics of the strategy and the direct impact the stock position may have on the overall income position of the strategy.

As part of the overall income strategy, to receive franking credits from a dividend, a buyer must hold their stock position ‘at risk’ for a 45-day holding period. This is an important consideration when executing an equity income strategy as selling options is considered a risk reduction strategy. This holding period was introduced as a result of local institutions buying franking credits from offshore institutions who couldn’t use the benefits of franking. Option strategies were introduced to eliminate any risk to both parties during these ‘franking stripping’ transactions. The ATO introduced the ‘at risk holding period’ to eliminate these derivative and franking transactions in the early 1990’s.

If you choose to execute this strategy via online brokers your stock position will be lodged as collateral. Its important to note that once the option trade has been unwound, through buying it back or letting it expire worthless, the stock position cant be traded immediately as it can takes days for the stock to be returned to your account. This will limit the ability of an investor to sell the stock immediately if required.

Its not as easy as it looks.

For the equity income professionals that manage this strategy there will be times when finding income will cause them headaches. There will be periods when they will be juggling dividends, options expiries, franking credit considerations, stock positions and importantly distribution periods to investors. There may also be periods when income cannot be distributed to investors. But for investors who require income more than capital growth the strategy has a long and successful track record in Australia. From experience it can be difficult to execute as a strategy over an entire portfolio.

For individual investors looking to execute this strategy themselves, look for periods of volatility in combination with a well-researched equity position. Benchmark the yield against similar company securities to determine the risk-reward scenario of the yield and always be aware of the tax and income consequences of selling your stock position.

Tim McGowen

About Tim McGowen

Tim McGowen is the co-founder of informedinvestor.com.au. He was previously the founder of Fortitude Capital the Hedge fund of the Year in 2008 & 2009. More recently he was a global Portfolio Manager for PM Capital.

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