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Oilweek Magazine: February 2013

Friday, February 1, 2013

Finding Yield
Income options for today's environment

David Sherlock
Portfolio Manager

As central banks around the world continue to lower interest rates, investors are having an increasingly difficult time sourcing attractive yields. The continued reduction in rates has pushed investors to buy large quantities of fixed income and, to some extent, high-yield stocks. Many investors recognize that they have paid up for future income and dividends, reducing yields.

Many are looking at the run-up in the recent markets and are wondering, “Where can one find value and yield?” “Is it still okay to buy government bonds?” “Is it too late to get back into the market?” 

It seems intuitive that further purchases of the same yielding securities (that all the other baby boomers are interested in) will be a crowded trade at some point. Some are concerned that this might already be the case. It is worth noting that the current yield on a Government of Canada bond is roughly 1.72 per cent. 

One strategy to create income from stocks near a top, or from stocks that are known to be volatile, is to sell covered call options. Energy stocks that pay modest dividends are prime candidates for this income solution, due to their economic sensitivity and market volatility.

Where a stock is optionable, covered calls allow investors who own a stock to sell call options against an equal amount of the stock, taking in a premium income. By selling a call option, the holder of the stock is basically pre-agreeing to sell the stock at a future date, at a known and fixed price. The closer the future sale price is to the actual price of the stock, the higher the premium paid. Also, the longer the option has until expiry, the higher the premium paid. If the stock never reaches the agreed sale price before expiry of the option, the seller gets to keep both the stock and the premium. The premium received goes to the investor’s bottom line by reducing the cost base of the stock. The premium creates a downside “cushion” in the event that the stock price slides. It also boosts gains on the upside until the strike price (the price that the option will force the stock to be sold at) is reached. Gains are capped above the strike.

This benefit comes at a cost. As long as the short, sold-or-written call position is open, the investor forfeits the stock’s profit potential above the option’s strike price. If the stock price rallies above the call’s strike price, the stock is likely to be called away (sold). Since the possibility of assignment is central to this strategy, it makes sense for investors who view assignment as a positive outcome, meaning you want to sell the stock above a certain price. 

Because covered-call writers can select their own exit price (i.e., strike plus premium received), assignment can be seen as success; after all, the target price was realized. This strategy becomes a convenient tool in equity-allocation management. Basically, you are
being paid an income to sell a stock, as opposed to paying a commission to take profits.

By selling calls, one gives another party the option to buy the security; this suggests that the stock owner who would regret losing the stock during a rally should think carefully before writing a covered call. The only sure way to avoid assignment is to close out the position. It requires quick action and extra cost to buy the call back, especially if the stock is climbing fast. The covered-call writer is looking for a flat to slightly rising stock price over the term of the option. The downside and the fear is a big pop in the stock price.

To illustrate, say an investor owns 1,000 shares of Suncor Energy Inc. (SU), which pays a modest dividend of 1.59 per cent (at the time of writing). If the investor believes it is unlikely the stock will close much higher than $35 in the near term, that investor could sell covered calls on SU for $36 for, say, Jan. 19, 2013. 

In return for giving someone the right to purchase the stock at or above $36, the investor would be paid a premium. In this case, the premium would be priced around 60 cents per share, or $60 per contract. The investor holding 1,000 shares could sell 10 call contracts for January 2013 at a strike of $36, for a total premium of $600, which is equal to 1.82 per cent in premium income, or 5.57 per cent if annualized. The call-option seller would enjoy roughly a 10 per cent gain on the shares from the current price to $36, the 1.82 per cent gain in income, as well as any dividends paid over the time frame. If the stock price declined 10 per cent, the net decline would be 8.18 per cent plus any dividends, and the seller would keep the stock. The covered-call profile dampens volatility and increases portfolio income.

The chart above is called a profit/loss chart. It captures the profit or loss for selling covered calls on 1,000 shares of SU. If SU’s stock price fell to $29, the sum of the stock’s decline and the gain of the call income would equal $3,330. If SU moves to a price where the stock has risen above the call strike price, we see that profit maximizes at $3,670, and the investor will have to “sell” the stock on assignment at $36, plus the call premiums, no matter how high the stock price rises.

Trading in options may seem a bit daunting at first, but such trades can dampen volatility and increase income. Options trade on a bid/ask basis, the same as stocks, so paying attention to the current bid (the price paid as a premium) is very important. Simply looking at the last price traded may lead to a lower-than-fair premium being received by a first-time call seller. 

Understanding the correct pricing of options can seem complex and requires some practice, so seeking experienced advice—as with all investing— is important.

The Internet has many good resources to help interested individuals learn more about options trading. For example, the Montreal Exchange (Canada’s derivative exchange) offers a dedicated page for investor education. It can be found at m-x.ca/accueil_en.php.

If one believes that the current rates offered in government bonds are challenging their income needs or that equity markets will be a volatile place to source retirement income, then it may be appropriate, profitable and exciting to explore the use of options strategies within your portfolio. Covered calls may offer a solution to create more income out of your volatile energy portfolio.

 

David Sherlock, Portfolio Manager
McLean & Partners Wealth Management Ltd.

For additional articles, please visit: www.oilweek.com


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