Professional Investment Strategies
At Landmark Financial, we keep our clients’ best interests at heart.
You will get quality advice for your investments from Landmark Financial’s professional, accredited and experienced advisors…who will be with you every step of the way.
Generate extra income
A low interest rate environment often prompts experienced investors to search for alternative forms of yield from their investment strategies. If you are looking for an investment strategy to help generate additional monthly income on top of your dividends with existing or new stock, you can take advantage of a low risk strategy such as a covered call.
What is a covered call?
A covered call is an investment strategy which can help produce a monthly income where the call option is sold against stock an investor already owns. In exchange for selling the call, you will collect a premium from the option buyer. However, the option premium comes with an obligation; if the buyer exercises the option, you will be obligated to deliver the underlying shares (sell the shares) to the buyer of the option at the sold strike price. As you already own the stock, you are ‘covered’ and can deliver the underlying shares, hence the name of the strategy, covered call.
Why write covered calls?
The goal is to generate extra income whilst keeping the underlying stock. Ideally the strategy is implemented when one feels that the stock is likely to move sideways or down and stay below the strike price of the sold call …resulting in the option position expiring worthless. In this instance you keep the option premium – as well as the stock – thereby generating an additional income on your existing holding.
This strategy is particularly good for stocks that pay stable dividends and enjoy a relatively stable stock price such as the major banks, miners and consumer staples.
HOW IT WORKS (EXAMPLE):
For example, assume that on January 1, Arthur owns 100 shares of IBM stock. IBM currently trades at $100, but Arthur is pretty confident it will stay below $105 for the near future.
To generate a little bit of extra income, he sells Jane a call option with a February expiration date and a strike price of $105. The call option is priced at $3 per share and it controls 100 shares. By selling the call option, Arthur receives a $300 premium today in exchange for the possibility that he will have to sell IBM stock to Jane for $105 between now and the February expiration date. By buying Arthur’s call option for $300, Jane has the right (but not the obligation) to buy 100 shares of IBM from Arthur at $105.
Now consider the following scenarios:
IBM trades at $103 at expiration. Jane’s option expires “out of the money” and is worth zero. She lost $300 on her trade.
Arthur gets to keep the $300 premium, plus his shares are now worth $300 more than they were worth on January 1. Arthur made $300 in cash and records a $300 paper profit.
IBM trades at $110 at expiration. Jane’s option is “in the money” and Arthur is obligated to sell her 100 shares for $105 per share, even though the stock trades at $110. Because she gets the shares from Arthur for $105 and can turn around and sell them for $110, Jane’s trade generated $500 minus the $300 she paid for the option, for a total gain of $200.
Now let’s look at the trade from Arthur’s perspective. Arthur’s 100 shares just went up to $110 from $100, for a $1,000 gain. But because he owes Jane 100 shares of stock and has to sell them to her for only $105, he loses $500 on that leg of the trade.
So Arthur’s trade looks like this: gain of $1,000 less $500 (because he must buy 100 shares of stock at $110 and sell at $105) plus the $300 premium = $800.
As you can see, by selling a covered call, Arthur has limited his upside potential in exchange for receiving the $3 option premium up front. The $1,000 gain from the increase in the value of the stock is split between Arthur ($800) and Jane ($200) via the call option.
To illustrate the point that his upside potential is limited, let’s assume that IBM traded at $115 at expiration and Arthur’s trade looks like this: gain of $1,500 less $1,000 (because he must buy shares at $115 and sell them for $105) plus the $300 premium = $800.
IBM trades at $95 at expiration. In this scenario, Jane’s option expires “out of the money” and is worth zero. She loses $300 on her trade.
Arthur’s stock holdings lost $500 in value, but the loss is buffered by the $300 premium he received for writing the call. If he has no intention of selling his shares and locking in the loss, he still gets to keep the $300 premium while he waits for the IBM stock to bounce back. To protect his holdings from future declines, he could buy a protective put option.
WHY IT MATTERS:
The safest way to sell an option is to write a covered call. The strategy is so safe, in fact, that it is suitable for most retirement accounts. In this type of trade, the investor sells a call option on an underlying stock that he/she already owns. A call option written against stock you don’t own is called a naked call.
In the long run, because options tend to lose their value as they approach their expiration date, selling options tends to be much more profitable than buying options. In particular, the covered call strategy works best when the investor plans on holding the underlying stock for a long period but does not expect a significant increase in the near term. The investor limits his/her upside potential in return for a guaranteed premium.
Covered calls are most common among investors who want to generate additional income from a particular holding. Naked options, however, are mainly used for speculating. The investor must be very confident about the direction the stock will go and have the resources available to cover any mistakes. With covered calls, the worst case is that the investor must sell the stock.
What if I don’t want to sell the stock?
Some times our clients are reluctant to give up the stock due to large capital gains triggering a Capital Gains Tax if sold. Although this risk cannot be completely eliminated – and the risk of losing the stock must be weighed against the potential premium that can be earned – there are ways to reduce the risk of getting called:
- Sell European style options. Unlike American options, European style options cannot be exercised until the last day of expiry. This allows the opportunity to “roll” the option forward or close the option before expiry to avoid exercise.
- Roll the option forward. Simultaneously buying back the existing contract and selling a European option further out in time. Rolling out in time or up to a higher strike gives the opportunity for the stock to pull back below the sold strike price. However this does not remove the obligation to sell the shares until the option has expired worthless.
- Close the option position for a loss prior to expiry, removing the obligation to sell the shares.
- Selling after a market rally or indication of potential weakness in an attempt to better time the sale of the option and potentially reduce the probability of the stock getting called away.
- Selling further “out of the money”. By selling the option much further above the current stock price you will reduce the risk of exercise and increase capital gain potential, however the trade-off is that you will receive less option premium for selling the call.
The risk of losing the stock is always there but with our expert investment advice, we can help reduce this risk.
Are there risks in covered call writing?
Covered call writing is generally considered to be a fairly conservative options strategy.
- Downside risk as a stockholder. As a stockholder, you are exposed to potential losses by holding the underlying stock. However, if you are a long term holder, you already understand the risk of holding shares and there is no additional downside. In fact, the sold premium helps cushion market falls by generating additional income when the stock moves sideways.
- Limited upside. As a pure stockholder, you have unlimited upside potential for the stock. Once you write a covered call, you are effectively limiting your upside potential. In effect, you are selling your upside potential for a premium and may be obligated to sell or deliver your shares to the option buyer.
Protection for your portfolio
Unfortunately, in modern markets, volatility is becoming the norm rather than the exception. Going to cash is often unattractive in a low interest rate environment with inflation eroding your nest egg. Just as you would be confident buying insurance for your home and car, you can use a ‘put’ protection investment strategy to protect your stock portfolio.
You can hedge your stock portfolio and manage risk using long puts as a protective investment strategy.
Portfolio insurance using puts
Investors concerned about declining markets can protect their portfolio against adverse market movements – without the need to liquidate their holdings – through the use of stock and index ‘put’ options. This has three advantages.
- Faster execution. Purchasing an index put can quickly reduce your long exposure across individual stocks held in the portfolio without the need to sell your stocks one by one.
- Lower transaction costs. Purchasing an index put means there is only one transaction involved, without having to close and pay brokerage for each individual holding.
- No CGT event. By buying put protection, you can reduce your long exposure or even go short with your portfolio without triggering a CGT event associated with selling stock. A lot of our clients have held stock for many years and a CGT event would be less than desirable.
Buying Puts Strategy – Why buy protection for your portfolio?
For many, a stock portfolio is their biggest asset and assurance for retirement. If you insure your car, house and income, why wouldn’t you also protect your stock portfolio? This buying puts strategy of using buying protection for your stock portfolio could be one of the smartest things you do for your future retirement.
For example, if the market drops 50%, it will take a 100% return for your investments to get back to what it was. In fact, the Australian market struggled to return to its 2008 highs of 6,600 index points more than 8 years after the GFC. If you were able to hedge your portfolio when the market dropped 20% you would have saved yourself 30% in subsequent losses.
However, there is a downside to buying protection. As volatility rises in more uncertain markets, protection will get exponentially more expensive as sellers demand more premium to take on the risk. However, with strategy advice from a Landmark Financial adviser, we can help you pick the opportune moment to buy put options for protection or even go short and position for a fall in the market.
Buying put protection example
Let’s say for example you own 1,000 shares in stock XYZ. You bought the stock for $50 and XYZ is now trading at $80; you feel the stock will fall in the short term and would like to protect yourself against this fall, but you don’t want to sell the stock.
In January, you buy 10 XYZ February put contracts at a strike price of $80 for $1 per contract. You will pay in cash $1,000 ($1 x 10 x 100) plus brokerage and you are protected until expiry in February.
If XYZ falls to $70 at expiry, the value of your put contract will be worth $9,000 ([$80 – $70 – $1]* 100 * 10). The value of the underlying stock would have depreciated by $10,000. Your net loss is $1,000, which is the premium paid for the contract. You can exercise your put option and sell your stock for $80 to the seller of the contract or if you would like to hold the stock, you can sell to close the option on market before expiry to lock in the option profit.
If XYZ stays above $80, you will lose the $1,000 in premium, which is the cost of the put option insurance. You can also sell this ahead of time before expiry if you feel the market will move back up.
Alternatively you can protect a portfolio with index puts. Each index put covers 10 times the value of the index price and is a quick and effective way to hedge a large portfolio.
What are the risks in buying put insurance?
The only risk you have is if the insurance contract expires worthless. In fact, this is the preferred situation as you would want your stocks to rise and for your capital gains to exceed the cost of the contract in the long term.
Diversify across the globe
Prudent investors should always be looking to diversify some of their portfolio into overseas assets
When it comes to international investment, Landmark Financial is unique.
Our clients can procure investment advice and stocks across many exchanges in the Americas, Europe and Asia via our international investment platform.