There is a safe way to squeeze more money out of your share portfolio than just collecting dividends and hoping your shares go up. If done correctly, this strategy can actually help you achieve returns better than the overall market and lower the risk profile of your portfolio.
To be honest, we can’t believe that so many people aren’t including this strategy in their share portfolio and what’s even worse; we can’t believe advisers refuse to recommend it, especially in today’s unpredictable world.
But the problem is, many financial planners and even some stockbrokers, for that matter, will tell you it’s too risky. Unfortunately, if your adviser says it is too risky, it is too risky……….. to be doing it with them advising you, because they obviously don’t know anything about how to do it.
The fact is, if done correctly, this single strategy can, on average, help you generate between 15% to 20%+ in annual free cash flow returns, and that’s before you receive the dividend. Plus, you also have the ability to earn a little bit extra in potential capital gains.
The strategy I’m talking about is called the Options Buy/Write Strategy or Covered Call Strategy. We are talking about using options contracts to generate additional income.
So what is it and how does it work? Put simply, it’s a two-stage process which involves:
- Buying shares in a company at a price you think is attractive, and
- Selling call options over those same shares which expire in a month or so’s time.
The idea is that you received cash in your hand, upfront, for selling someone else the right to buy your shares at today’s price or a price slightly higher than where it is today. And while waiting for either the contract to expire or the shares to be called away, you get to keep the dividend the company pays while you remain a shareholder in the company.
But let’s be clear, I’m not talking about selling naked call options. Selling naked call options is one of the riskiest strategies in the market today. It’s so risky in fact that it is not allowed to be used in Self Managed Superannuation Funds. That’s because your gain is limited but your potential loss is theoretically unlimited, plus it breaches borrowing rules. But by simply changing one thing, that is, by buying shares first and selling call options over the shares you own, you are essentially trading away the potential for huge capital gains in favour of more steady, but very attractive levels of income.
Now let’s face it, where are the huge capital gains in today’s share market? And how consistently do you think returns of 15% to 20%+ can be achieved over the long term by simply just hoping for your shares to go up?
When looking to do this strategy, one should know a few rules:
- Only buy shares in a company you want to own and which you believe represents value
- Only buy shares in a company you know is financially secure, and
- Only buy shares in a company you want to own, that is financially secure and has experienced a recent sell-off
The first two rules should be well known to every value investor, but you’d be surprised how often these rules get broken, even by professionals.
But it’s the third rule, which not only helps you become a better investor but which also helps you to earn juicier free cash flow returns. One of the most influential factors in determining how much money you’ll received for selling your call options is how volatile a stock price is.
Now let’s consider a couple of points:
- Is the stock market riskier before or after a crash has happened?
The answer is ‘after’ of course, because theoretically the crash has already happened and valuations should be cheaper, at least for high quality businesses.
- Is insurance more expensive after a natural disaster or before?
The answer is ‘after’ the disaster of course.
By writing call options over shares you own, you are essentially insuring someone else against a price rise in your shares. That someone may be waiting to receive cash but doesn’t want to take the chance the shares are going to rise before they can afford to buy them.
So, as the insurer, you receive a premium for selling someone that right, but not the obligation, to buy your shares at a price close to today’s price.
Typically option premiums become more expensive when the share market is declining or has declined. But the risk of owning shares is reducing as they become cheaper to buy. If you look for shares that have already sold-off, are attractive from a value perspective, have started to find a price floor and are financially sound, then not only are you receiving more in premiums, but you are also buying shares at cheaper prices with better yields.
So how has this strategy performed over recent years?
The chart below of the ASX 200 Buy/Write Index, which replicates this strategy being applied over just the ASX 200 Index, that is, it doesn’t consider value or price floors, has outperformed the ASX 200 Accumulation Index (includes the impact of reinvested dividends) by a whopping 60% since the peak in the ASX 200 in 2007. That is, the lazy man’s buy/write strategy is 28% above its 2007 highs while the ASX 200 Accumulation Index needs to rise a further 22% just to break-even.
And that’s being lazy.
But don’t just look at the returns, what about the risks. Well during the GFC, if you were a lazy man, the strategy would have lost 32% during the GFC versus the ASX 200 Accumulation Index’s 50% decline, but it took less than 1 ½ years to get back to the previous high in 2007 while the ASX 200 Accumulation Index still lays flat on the canvas. And over the past 8 years the strategy is up over 100%, even with the worst bear market in the past 40 years during that time.
The fact is, you don’t have to accept sub-par returns and high risk. You can do something about it today.
Make the decision to secure your financial future and contact one of our qualified financial strategists to discuss this strategy in complete confidence and with no obligation.
By the way, as good as this strategy is, we believe that there is an even safer way to use options and generate great levels of income, but you’ll need to call UGC today and speak with one of our strategists to get the scoop on this one!!