SMSFundamentals: Zero Cost Return Enhancement (Examples)

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.

For an introduction and story archive please visit FNArena's SMSFundamentals website.
 

Note: This article was first published for subscribers on May 8, 2012.

By Greg Peel

Required prior reading for this article is FNArena's previous SMSFundamentals article How Retirees Can Improve Returns While Reducing Risk. Otherwise this article won't make a lot of sense. This article provides specific examples of the options strategy outlined in the earlier article.

This article is a response to a specific query from valued FNArena subscriber Tony Wasson. FNArena thought it would be a response best shared and we thank Tony for his correspondence.

Since the former article was published we've seen a 50bps rate cut from the RBA which will now impact on rollover rates available for bank term deposits as well as reducing entry yields for fixed interest investments. Expectations are for further RBA cuts. In short, the term deposit honeymoon is over, and that's not good news for Australia's self-managed retirees.

We are also now suffering another bout of euro-fear, right on time for the annual Sell in May thesis. It is not necessarily the best time for SMSFs to be barrelling back into shares but when the dust settles, requirements for retiree income will force SMSFs to reconsider equity investment once more. To reduce the risk of stock investment – providing a “sleep at night” factor – without having to sacrifice too much return, the previous article outlined a longstanding exchange-traded options strategy which has been used for decades by institutional funds managers. Here we provide two examples of such a strategy on current pricing, in this case for Rio Tinto ((RIO)) and National Australia Bank ((NAB)).

Please note that while this article refers to “zero cost” return enhancement, it is rarely possible to balance the price paid on a long put and the price received on a short call exactly to zero, given a limited exercise price range. So please assume “zero” to mean “minimal cost”.

Example 1: Rio Tinto

Strategy: 

Buy 100 Rio shares at $61.46.
Buy 1 Rio $54.41 December expiry put option at $2.67.
Sell 1 Rio $68.51 December expiry call option at $2.45.

Cost is a net 22c on 100 shares. One option represents 100 shares.

Upside:

If Rio's share price is at or above $68.51 at expiry of the option, the call option is “called” which is the equivalent of selling the shares purchased at $68.51. Capital gain is $7.05 less 22c cost, or $6.83.

Downside:

If Rio's share price is at or below $54.41 at expiry of the option, the option is “put” which is the equivalent of selling the shares purchased at $54.41. Capital loss is $7.05 plus 22c cost, or $7.27.

In summary, the investor risks a known limit of $7.27 on 100 RIO shares to make a known limit of $6.83. On the downside you're happy to be out, on the upside you have simply taken profits ready to play again. 

The reader might be quick to point out that the upside is actually less than the downside due to the cost, but consider this: when you turn out the light at night, which are you more fearful of? A stock market crash or a very sharp rally? And when we move on to the next example, we'll see it can work out both ways.

There will also be a dividend to consider during the period, which means the value proposition actually skews back towards the positive. Rio's yield is not material so the specific adjustment is not made in this example, but adjusting for the dividend will be important in a high yield stock such as a bank.

Example 2: National Australia Bank

An important consideration when trading high-yield stock options is that of any dividends paid in the period. Options on dividend-paying stocks do not themselves pay a dividend, but option prices will take account for dividend payments within the premium cost. An option does not “go ex-dividend” as a stock does, but rather the premium at any time will always reflect a dividend known to be due within the period.

Such a consideration is particularly required for the banks, and hence the following example illustrates how it all works. Note that over the period used in the example, two dividend payments will be made.

Strategy: 

Buy 100 NAB shares at $24.27.
Buy 1 NAB $20.00 December expiry put option (American style) at 68c.
Sell 1 NAB $25.51 December expiry call option (European style) at 51c.

Cost is a net 18c on 100 shares. One option represents 100 shares.

Upside:

If NAB's share price is at or above $25.51 at expiry of the option, the call option is “called” which is the equivalent of selling the shares purchased at $25.51. Capital gain is $1.24 minus 18c cost or $1.06.

Two 88c dividends will be paid over the period for $1.76 hence a total return of $2.81 before making any assumptions on full franking credits.

Downside:

If NAB's share price is at or below $20.00 at expiry of the option, the option is “put” which is the equivalent of selling the shares purchased at $20.00. Capital loss is $4.27 plus 18c cost or $4.09.

Two 88c dividends will be paid over the period for $1.76 hence a total loss of $2.69 before making any assumptions on full franking credits. 

In summary, the investor risks a known limit of $2.69 on 100 NAB shares to make a known limit of $2.81. On the downside you're happy to be out, on the upside you have simply taken profits ready to play again.

Important To Note: 

The above examples are provided using prices available at a snapshot in time. The prices of the stock and call and put options are all fluid and hence net returns will also fluctuate depending on available pricing at the time of execution. It will always be possible, nevertheless, to identify an option combination for this strategy at a minimal cost.

Like listed shares, exchange-traded options can be bought or sold at any time up to expiry. The investor can thus change his or her mind, sell the puts, buy back the calls, exit the entire strategy or roll the strategy out to the next expiry date ahead of the first expiry, thus perpetuating the trade. No one is locked in to anything, just as an investor can buy or sell shares at any time.

FNArena strongly recommends you contact your stockbroker for advice before engaging in such strategies when inexperienced.

 
Trade strategies described in this article were designed by Stuart McClure of OctaPhillip Securities. To find out about implementing such strategies, email smcclure@octaphillip.com.

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