What’s Even Better than Dividends?

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A quick look in the letterbox; a scan of your inbox. It can be a long wait for that dividend statement to arrive.

Tapping your fingers on the desk. Staring longingly — dare I say, lovingly — out the window for the postie to arrive. Your ear acutely attuned to the sound of an arriving two-stroke.

Oh, what joy it brings when that dividend money finally lands in your account.

Some funds pay out distributions every quarter. That’s pretty handy when you are relying on that income to help pay your bills.

Older, more blue chip stocks, though, typically only pay dividends twice a year. It’s a bit like Christmas and your birthday, but spread out more evenly, with dividends arriving six months apart.

To generate some additional income above these regular dividends, some funds write (sell) call options over their shareholdings — something private investors can do as well.

Note that when your initial trade is to sell an option — as opposed to selling an option you have previously bought — you are ‘writing’ an option.

Doubling up

Writing options on shares can help spruce up your income. If you get it right, it can even double your income, or more.

But unlike waiting an eternity for your dividend check to arrive, with options it is quite different. The money you receive from writing the option lands in your account the very next day.

To be clear, in return for receiving that premium, writing a call option comes with an obligation. That is, you must hand over your shares at the option’s strike price, if the option buyer exercises their option.

Not such a big deal, right? It all seems straightforward.

However, writing call options over shares is off the radar for so many investors.

Perhaps it’s a basic fear of what options are about. You constantly read and hear how risky options can be.

Or maybe it’s something a bit more basic. That is, that they just haven’t had time to learn about options…or gotten ‘round to opening an options account.

However, there is also something more pragmatic. While writing call options can help load up your income, it can also limit your profits. And that stems from what I mentioned about obligations.

By writing that call option, you are agreeing to hand over your shares at the option’s strike price. If you write some call options, and the share price goes on a tear, you could end up leaving some money on the table.

For example, if you write call options at $5, and the share price rips to $6, you still have to hand over your shares at $5, if the option buyer exercises their option.

This alone can be enough to put investors off from writing options. So what can you do?

The rationale

To understand how to approach this dilemma, you first need to understand why we write options. Yes, as discussed, we want to generate premium, thereby adding to our income stream.

The way we achieve this, though, is by capturing something inherent in all options — time decay.

Because all options have a finite life, they lose a bit of value every day. A little bit at the start, this time decay accelerates the closer the option gets to expiry. Once an option expires without exercise, it has no value at all. And this is what we are trying to capture when writing options.

So how do we capture time decay, yet not lock ourselves into handing over shares below the market price, if the buyer exercises their option?

Roll up, roll down

We do this by rolling our option higher. As the name implies, it means rolling out of one option and into another. In the case of a call option, that means buying back the written call option, and then writing another at a higher strike price.

The difficult thing, though, can be the timing. If you try to buy the option back too soon, it will still have a lot of time value. Meaning that you will need to pay a higher premium.

What you want to do, is buy the option back as late as possible, so that most of the time value has gone. That means you will be paying less premium to buy it back — you then write a higher strike call option with a later expiry.

If you get it right, you can still generate some premium into your account, and, lock in a higher exercise price for the new option.

Rolling an option works both ways. You can also roll an option down if the share price falls. Again, though, after capturing as much time decay in your open option position as possible.

It can be a bit of a tradeoff. If you wait too late, and the share price continues to fall, you can end up writing the next call option at a lower strike price than you wish.

In that case, it can sometimes be better to pay up to buy back your open option position, and write your next option at a strike price you wish.

When writing options, you always have to understand your obligations. With a call option, that means handing over the shares at the option strike price if the buyer exercises their option. And this is where the strategy might seem limiting.

However, by learning to roll options — either up or down — you can take advantage of something else inherent to options — their flexibility. Plus, add some extra income to your kitty.

All the best,

Matt Hibbard,
Editor, Options Trader

About Money Morning Editorial

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the…

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