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Using Options for Income

For Those Who Like the Bird in the Hand

As a financial planner, I generally despise uncertainty. When clients ask me whether they will be able to stop working this year and have the money to achieve their retirement goals, I hate that I can’t answer their question with a categorical, etched-in-stone, 100% guaranteed, resounding “yes!!!” No matter how hard I try, however, this is not going to change. In the end, my world is one of probabilities rather than certainties, so I will act accordingly. Since I will never be able to accurately predict all of the myriad variables that go into assembling a financial plan — such as lifespans, inflation, future tax changes and client health — I see my job as tweaking the odds in my clients’ favour to the greatest extent possible through techniques like tax planning and insurance, as well as making sure that all of the legal “t’s” have been crossed (although there will always still be a few “if, ands and buts” lurking in the background).

Those of you who’ve read my words carefully so far, however, have probably noticed that I have not yet mentioned perhaps the most unpredictable yet important planning assumption for many of us: how will my investments perform? Like many of you, I’ve grown tired and frustrated watching the stock market and my individual investments bounce around in a seemingly random fashion like balls in a pinball machine, and been shocked at how little many fixed-income investments, e.g., bonds and preferred shares, yield, particularly in light of some of the risks involved. I won’t even bother discussing GICs, whose only current guarantee is that, after inflation and taxes, your GIC portfolio won’t have the same purchasing power down the road that it has right now.

While I haven’t found a silver bullet to combat investment uncertainty, I do feel I’ve found a few 38-calibre slugs that are definitely a step in the right direction. The one I want to discuss today is using “call options” — the right to buy a stock at a set price, aka a “strike price,” within a set time period (regardless of what the stock is actually trading at then) to generate extra cash flow from a blue chip dividend-paying portfolio.

In a nutshell, by selling a call option, you can earn extra money (an “options premium”) to combine with the dividends you’re already receiving from these stocks in exchange for surrendering some, but not all, of the upside. If the stock either goes down in value or climbs to less than the strike price, the call option expires, but you will still get to pocket your options premium, along with the dividends the stock normally generates. If the stock soars, you’ll be forced to sell at the strike price and will have lost out on any capital gains over and above that amount. On the other hand, you can take solace in the fact that, in addition to the dividends and options premiums that are still yours to keep, you will have also made perhaps a 2%–8% capital gain as the cherry on top of the income payments. When you also realize that this additional capital gain has probably occurred over only a couple months, you might feel even better when you calculate that a 3% bump over two months translates into a 18% annual return…without even factoring in dividends and the options premium.

Let’s put theory into numbers. The numbers below have been prepared by Thomas Tsiaras, a battle-hardened investment professional with Industrial Alliance Securities in Vancouver that I’m delighted to have manage some of my own and my clients’ money. This example is based on May 3, 2016 trading prices.

If you own Bank of Nova Scotia — then trading at $63.43 per share — you could sell a call option open until July 2016 agreeing to sell your shares at $66 for an options premium of 1.34%. In other words, you have capped your upside to 4.5% over two months. If the option is never exercised, your combined dividend and options premium for that period translates to an annual yield of 9.88%. If it is exercised, then you get to add an annualized capital gain to this amount. When you realize that this gain would have occurred over two months, the 4.5% capital gain you would have received over these 60 days translates into an annual gain of about 27% to add on top. Thus, even if you miss out on some of the upside, you’ll be able to enjoy a return over this two-month period that, before costs and taxes, leaves you around 37% in the black!

A Few More General Points on Call Options Trading
I suspect that those of you who’ve made it this far have a lot of questions still to be answered, particularly those not familiar with options. I plan on providing more detail about the world of options trading in future articles, but here is some additional information that I hope will tide you over until then.

Taxation of Options Premiums
If you’re like me, it’s far more important to know what your investments yield after the tax man has come and gone rather than what things look like before he has entered the building. In this case, we’re talking about a good news story: options premiums earned in non-registered accounts are taxed as capital gains. That means you pay about 50% less per dollar of income from options premiums than you would if receiving interest payments. Moreover, if you have capital losses from other investments already on the books, the story just keeps getting better: you can keep your options premiums tax-free until you’ve used up all of those previous capital losses.

Eligibility for Registered Accounts
You can own options inside an RRSP, RRIF or TFSA provided you’ve authorized the account to own these types of investments. For those of you who don’t want to trigger taxable capital gains along the way because you’re in a high tax bracket, investing inside a registered account might be the way to go.

Costs and Fees
I recommend, if you’re interested in options investing, that rather than doing it on your own you work with a stockbroker who can do it for you. Most brokers don’t do options trading, and those who do often won’t do it unless you pay them an annual percentage fee based on the value of the account, plus a small charge per trade (rather than exclusively on commission). Many require a minimum account size as well. In addition to selling call options, you would need to reinvest the money you receive if your stock is “called away” (i.e., if someone exercises the call option to purchase your stock at the strike price).

For example, Thomas only works with portfolios of a minimum size of $150,000 and typically charges $30 per stock trade and $35–$45 per option trade, plus 1% of your portfolio value as an annual fee — actually, the same fee often charged by brokers who don’t do options trading. Although many buy-and-hold investors like either to do it themselves or pay on a commission basis, this might be one situation in which the annual fee makes sense. As a consolation, the fee on non-registered accounts is 100% tax-deductible.

Thoughts on Surrendering the Upside
I suspect that one of the biggest drawbacks to many investors is the thought of losing the upside if the stock on which they sell a call option doubles in price overnight. When mulling this over myself, I quickly realized that I was more than happy to make this choice in order to potentially double my income along the way, particularly since the sort of stocks in question — blue chip, high dividend payers — aren’t usually that volatile. For example, for Bank of Nova Scotia, what are the chances of the stock going up much more than 4.5% between now and July? Moreover, if it did, I wouldn’t really have missed out until the stock had increased in value by more than the 5% additional money I received upfront in options premiums. Thus, in some cases, I can still be further ahead than an investor owning the same stock who decided not to write a call option, even though I get “stopped out” (forced to sell my stock at the strike price).

Also, I also realized that the more volatile the market and the price of the stock in question, the higher the option premium I would get for selling some of the upside. Investors will not bother writing call options if they are not adequately rewarded for surrendering that prospect future gain when such a gain appears likely. Alternatively, I always have the choice as to the strike price I would set when writing my call. The smaller the gap between the current stock price and the strike price, the higher the options premium, since the chances of the option being “in the money” (i.e. the market value of the stocks are higher than the strike price so that the person buying the call option will make a profit) that much higher. Thus, I can continuously manage my mix of options premiums and potential capital gains throughout the year, depending how bullish I felt about my stocks or the market in general from time to time. If I feel strongly that great things are in store for a stock over the coming months, I can accept a smaller options premium so I can keep more of any potential capital gain or even forgo writing an option if I want to keep the entire potential gain for myself.

On a final note, continuing with the Bank of Nova Scotia example Thomas detailed earlier, I suspect that many investors who didn’t write call options wouldn’t automatically sell in July 2016 if the stock were trading at, say, $70 per share, which would have been $4 higher than the strike price used in his example. Accordingly, although they are ahead of the game in the short term, if the stock turned around and retreated back to $63 over the next two months, I would still be the one having the last laugh, as their gain was only on paper and I would still have the options premiums in the bank.

Buying Back Called-Away Stocks
If your optioned shares are called away and you are forced to sell at the strike price, there is nothing to stop you from buying back the shares you just sold. If you decide this is the way to go, then you need to know that you will be getting a slightly lower yield from the repurchased stocks than the ones you sold. For example, if you have $10,000 worth of shares yielding 4% that go up in value to $12,000 without increasing their dividend payments, someone buying the shares when they are worth $12,000 would still be getting $400 in dividends per year but would have had to spend an extra $2,000 to get the same payout. In other words, the first investor was getting a 4% dividend yield based on the stock’s trading price then, while the second would be earning only 3.33% even though both own the same number of the same stocks and get equal yearly payments. In reality, this wouldn’t make a difference unless the value of the stock at the time the call option was exercised was dramatically higher, such that the extra money generated in options premiums, plus the sales proceeds when your stocks were called away, weren’t enough to buy back the same number of shares you sold.

This also assumes that buying back the same shares at the higher price is your best decision at that time. For example, even if the options premium and dividends earned along the way would allow you to repurchase the same number of shares in the old stock that was called away at the new price (so you could still earn $400 per month in dividends), you might be better off to invest in a new stock that paid a 4% yield now. In other words, buying a new stock paying 4% rather than repurchasing your old stock that is now paying 3.33% would get you $480 rather than $400 per year in dividends. Thus, in some cases, investors picking a new investment after being called away might actually increase their income payments going forward compared to their buy-and-hold friends.

Tax Implications of Additional Buying and Selling
One downside of having stock called away is having to realize capital gains during years when you’re in the higher tax brackets; losing the ability to compound gains for years upon years without triggering capital gains tax is definitely a drawback. If you haven’t been using your RRSP contribution room or have unused capital losses on file, then upping RRSP contributions to your own or a spousal account can make sense, or perhaps using prior losses to offset your current gains.

If you don’t have losses on file and either don’t have or don’t believe in RRSPs, then it will become even more important to look at tax planning options to minimize the tax bite. One size does not fit all in this situation, but some ways of reducing the yearly tax hit include using spousal loans (if there is a big difference between spouses’ tax brackets), using trusts to income-split with other relatives (depending on their ages) and, potentially, investing inside corporations if the company can pay dividends to lower-income beneficiaries. Other investors might also consider using investment loans to leverage their investments and create deductible interest to reduce the investment tax bill, although this needs to be discussed carefully.

Ultimately, although I hate losing tax deferral, I am okay with it in this situation because it will only happen when I’ve made a healthy return, i.e., a lot of times the call options I write will expire unused, so that I can continue to buy and hold until I either decide to sell the stock myself or it is eventually called away after a nice run up in value. Also, I take into account that the extra income I receive in options premiums is taxed as capital gains rather than interest, which means that the money I receive from dividends and options premiums goes a lot further than if I were getting interest from a bond. Finally, quite simply, if it’s a reasonable return, I am happy to give up speculative future capital gains at lower tax brackets in the distant future in exchange for guaranteed money in the bank today.

Conclusion
In some ways, I feel as if I’ve started in the middle of the options story rather than properly setting the stage by starting at the beginning of this epic tale. For those of you who agree, I will try to make it up to you in future articles in which I provide more background information on options trading — including details about how some other investors use this strategy. Until then, I hope I’ve reminded you of the value of considering your (investment) options carefully.

 

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