The “buy-write” or covered call strategy is slowly gaining acceptance among mainstream investors and is being offered by a growing number of portfolio managers as a strategy for reducing risk and increasing income from a share portfolio. However, selling cash secured puts still remains a bit of a mystery to most Australian investors. A practitioner of our Low Risk Income Strategy (which includes selling cash secured puts) was recently told by his tax accountant that doing covered calls was fine but selling puts was definitely a “no-no” as it was considered too risky. As tax time is around the corner, I thought this might be a good time to write a couple of articles to demystify the “cash secured put strategy” and show how this strategy can be less risky than buying shares or selling covered calls.
Let’s look at RIO, a blue chip stock which currently has a BUY recommendation from a number of analysts and is considered a good buy at today’s price of $54.69. Below is an option chain for RIO (click to enlarge) when it was trading at this price:
An investor who wishes to invest in RIO shares will have to pay market price i.e. $54.69 to buy the shares today. If the share price falls below $54.69, this investor will immediately incur unrealised loss in his investment.
An investor who sells covered calls will also have to buy RIO shares at market price i.e. $54.69. He could immediately sell a $55 call and collect $2.65 of premium for the call, based on the prices shown in option chain above. This will effectively reduce his cost to $52.04 ($54.69 – $2.65) and this investor will not incur any loss unless the share falls below $52.04.
An investor who sells cash secured puts does not need to pay market price for the shares. He can make an offer to buy the shares at below the market price. For example, he can make an offer today to buy RIO shares at $50 any time before July 25 by selling RIO July $50 put options. Based on the prices shown in option chain above, he will also be paid $1.05 per share for selling these put options, which will further reduce his cost to $48.95 ($50 – $1.05) per share, should his offer to buy at $50 get accepted. This investor will not incur any loss unless RIO shares fall below $48.95.
From the above example, it should be quite easy to see that selling cash secured puts is less risky than simply buying shares and could be even less risky than selling covered calls. As a risk averse investor, selling cash secured puts is my favourite way for buying shares that I like to own long-term like RIO. I have been using this strategy in my SMSF for over four years, and selling the RIO $50 puts is a real trade in my SMSF. As long as you have cash (or other liquid collateral) to cover the put options you sell, there is no problem with SMSF compliance.
If your tax accountant has a problem with you selling covered calls or puts, do refer him or her to this document “Tax Treatment of Exchange Traded Options” on the ASX website which was written by a Partner from Deloittes, Touche and Tomatsu Ltd, a well-respected accounting firm. The link to this document can be found on our Resources page.
While on the subject of tax, income from selling options is considered capital gains for SMSFs and investors. If you have made some money from selling options in FY2013, you may want to consider selling some stocks which have fallen value to offset the capital gains from your options. For example, I am considering selling some of my Newcrest shares before June 30 to realise the capital loss on these shares and I will sell some cash secured puts to buy them back in FY2014. However, do remember “wash sales” or selling just for the sake of avoiding tax is not allowed, so selling 1000 Newcrest shares and buying another 1000 shares on the same day is probably not a good idea.
I hope this article has helped to put to bed any misconceptions that selling cash secured puts is riskier than buying shares or selling covered calls. In my next article, I will show how selling puts can be safer buying stock for dividends. Stay tuned!