Note to new readers: This is a regular update on the status of our Low Risk Income Model Portfolio which is built using the income strategy described in our e-book “A Low Risk Income Strategy for All Economic Conditions”

The Greek elections is over and thank goodness there were no nasty surprises to cause the stock market to crash as feared. Although the European debt crisis is by no means over, at least there is rational leadership in place to slowly work through the crisis. Today we will put on a new covered call trade on Telstra, a popular income stock to demonstrate how we can reduce risk and increase our income using options.

Trade Transactions This Week

Telstra: TLS September $3.51 Call

From the chart of TLS below, we can see that the price of TLS has been on an uptrend since early 2011. Unlike the mining stocks, TLS has not been affected at all by the recent stock market correction. Based on the Vector Vest valuation, TLS is valued at $3.29 so it is a little overvalued at the current price of $3.63.

The current price of TLS is a little higher than what I would like to pay for the stock. However, we can expect the stock price to remain high as many income investors are buying TLS because it pays a generous fully franked dividend. Even at today’s price of $3.63, the gross dividend yield (including franking credits) is still a very attractive 11% per year which is almost double what we can get from term deposits. Based on the dividend history shown in the table below, the final dividend distribution is coming up in August, which is just two months away.

Source: CommSec (click to enlarge)

To reduce our cost (and hence risk) of owning TLS stocks, we can sell some ITM calls after we buy the stock. As we need to own the stock when it goes ex-dividend in August and hold stocks for at least 45 days in order to collect franking credits, we will sell September calls. To ensure our stocks do not get called away before they go ex-dividend, we will sell European style options which cannot be exercised before the expiry date. From the option chain below, we can collect a premium of 12 cents for a September $3.51 call option.

Source: CommSec (click to enlarge)

As our allocation per position is $30,000, we can commit to buying up to 8264 shares ($30,000 / $3.63). We will buy 8000 shares at a cost of $29,040 ($3.63 x 8000 shares) and sell 80 call option contracts. We will receive $960 ($0.12 x 8000 shares) of option premium for selling the calls.

Like most stocks that pay big dividends, TLS tends to fall in price after the stock goes ex-dividend so I expect the stock price to fall below $3.51 in September. Our primary exit is for our call options to expire worthless and we can then sell another call option to generate more income while waiting to collect the next dividend which is due in February 2013.

Our secondary exit is for our call options to get exercised. If the TLS stock price remains above $3.51 on September 27, we will have to sell our TLS shares at $3.51 and incur a capital loss of 12 cents per share since we bought the shares at $3.63. However, we would have already earned 12 cents of call premium, 14 cents of dividend and another 8 cents of franking credit by then. Our net return is 5.7% in just over 3 months or an annualised return of 21% which is still a great return.

Model Portfolio Update

Rio Tinto: RIO July $64.00 PUT

On April 18, I sold to open RIO July $64.00 put options for $2.04 when RIO was trading at $66.08.  RIO shares fell sharply in the recent correction but have rebounded strongly since last week and is trading at $57.79 today and our put options are now valued at $6.40.

For more information about this trade set up, read my April 18 model portfolio update.

Wesfarmers: WES June $29.50 PUT

On April 24, I sold to open WES June $29.50 put options for $0.59 when WES was trading at $29.64.  WES is trading at $29.57 today and our put options have fallen to $0.25. Our put options are currently ATM and if the price of WES falls below $29.50 on June 26, which is the ASX option expiry date for the month of June, we will be assigned WES shares at $29.50. If that happens we will immediately look to sell covered calls on our shares to generate income while waiting for the next dividend to be paid in September.

For more information about this trade set up, read my April 25 model portfolio update.

Newcrest Mining: NCM July $24 PUT

On May 9, I sold to open NCM July $24 put options for $1.24 when NCM was trading at $24.24. Newcrest’s stock price seems to have found support at $24 and is trading at $24.81 today. Our put options have decreased in price to $0.81.

For more information about this trade set up, read my May 9 model portfolio update.

Iluka Resources: ILU July $13 PUT

On May 16, I sold to open ILU July $13 put options for $0.78 when ILU was trading at $13.07. Iluka’s stock price has rebounded slightly since last week and is trading today at $12.40, which is still below our strike price.  Our put options are now worth $1.04.

For more information about this trade set up, read my May 16 model portfolio update.

National Australia Bank: NAB September $24.01 CALL

On May 30, I sold to open NAB September $24.01 call options for $0.76 when NAB was trading at $23.76. As expected, NAB fell in price after the stock went ex-dividend on May 31. NAB’s stock price has rebounded strongly since last week and is trading at $23.51. Our call options are now worth $0.78.

For more information about this trade set up, read my May 30 model portfolio update.

Woolworth: WOW August $26.00 PUT

On June 6, I sold to open WOW August $26 put options for $0.65 when WES was trading at $26.24. Today WOW is trading at $26.52 and our call options are now worth $0.42.

For more information about this trade set up, read my June 6 model portfolio update.

Current Open Position Snapshot

A summary of our open positions is shown in the table below. We have 5 open put positions and 2 open covered call positions.

I will be providing a weekly update on this model portfolio on this blog. If you are intrigued by our income strategy but have trouble following the discussions in this post, you will need to first download and read our e-book in order to understand the strategy and do some basic options education (found on our Resources page) to familiarise yourself with option terminology.

Stay tuned!

Disclaimer: This post is for educational purposes only and should not be treated as investment advice. This strategy would not be suitable for stock investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek investment advice if required.

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