One of the components that enables Djerriwarrh to pay a higher yield to shareholders is its approach to selling options over part of its portfolios. This generates income from the premium that Djerriwarrh receives for selling the options. It’s a relatively involved investment approach, but one that delivers value to shareholders. We provide a brief explainer in this article to help you understand.
What are options?
An option is a contract that gives the buyer the opportunity, but not the obligation, to buy or sell an underlying asset, such as shares, at an agreed price (called the strike or exercise price) and by an agreed date (called the expiry).
In an options contract, the buyer pays the seller (the writer of the option in the case of Djerriwarrh) a premium for the rights granted by the contract. The premium is the cost of the option. The premium depends on factors such as the current price of the stock, when the option expires, interest rates and the underlying asset’s volatility.
Each contract has an expiry date by which the holder must exercise their option. The buyer can sell the option before it expires (called closing the position) or let the contract lapse upon expiry but forgoes the option premium that they paid to the seller.
Types of options
There are two types of options: “call” options and “put” options. Call options allow the buyer to buy the underlying shares; put options allow the buyer to sell the underlying shares.
In using predominantly call options, Djerriwarrh uses both American and European call options depending on the underlying company holding and market conditions.
American and European options have similar characteristics, but the differences are important. For instance, owners of American-style options may exercise at any time before the option expires. On the other hand, European-style options may only be exercised at expiration. In the example of European options, Djerriwarrh can sell a European option and have certainty about keeping any dividend that may occur prior to the option exercise date.
Djerriwarrh’s approach to options
We predominantly write call options but also write a small number of put options. Call options are only written over securities held in the investment portfolio whilst put options are fully backed by cash, cash equivalents (assets that can be converted into cash immediately, such as short-term government bonds) or access to liquidity facilities.
The amount we receive from selling options depends on several factors:
The options usually have an expiry date within three to six months from the date that they are sold.
We prefer the options to either lapse at expiry or, prior to exercise, to seek to buy back the options and sell new options further out and preferably at a higher exercise price.
Sometimes, where the share price of a company increases strongly, we do decide to allow the shares to be exercised when we believe it is in shareholders’ interest to allow it to occur.
Gains or losses on disposals of investments upon the exercise of such options, after applicable tax, are taken to the realised capital gains reserve. Any gains when taxed are available for distribution to shareholders as fully franked dividends.
Our options strategy at work
The management of the option positions helps us deliver an appropriate balance of enhanced income and capital growth for our shareholders. In terms of our overall option strategy to generate additional income, our goal remains to write specific single stock options against companies held in the portfolio, rather than setting an overall target for option coverage for the portfolio. This is done in order for Djerriwarrh to meet its enhanced yield objective, but only to a level where long term capital growth is not overly compromised.
For example, in the 2020-21 financial year, after beginning the year with option coverage (as a percentage of our portfolio) at 33 per cent, it was reduced from 35 per cent at the end of November 2020 to 28 per cent in February 2021, as many profitable option positions were closed to capture option premium income.
Option coverage was not immediately rewritten at this point, so that we could preserve exposure to potential share price gains. As the share market subsequently increased to all-time highs, option coverage was gradually lifted to 38 per cent by the end of June 2021.
These strategies generated significant option premium income, whilst largely preserving the capital growth delivered by the rising share market. Consequently, Djerriwarrh’s total portfolio return, including franking, for the 12 months to 30 June 2021 was 29.6 per cent—above the S&P/ASX 200 Accumulation Index return, including franking, of 29.1 per cent.
Our investment philosophy is built upon taking a medium to long-term view on holding positions in our portfolio, with an emphasis on identifying quality companies that are likely to sustainably grow their earnings and dividends over this time.
Options help generate recurring income. We monitor option positions daily, and our portfolio is managed with the aim of maintaining an appropriate balance between capital growth and income generation.
Our options strategy is a key component of providing our shareholders with an enhanced fully franked dividend yield above the S&P/ASX 200 Index.