In the hunt for yield, another popular income strategy is to buy shares shortly before they go ex-dividend and then sell them after 45 days in order to collect the dividend and franking credits. With this “ex-dividend” strategy (also known as the “dividend stripping” strategy), it is possible to collect more than the 2 dividends a year that you normally get from just holding shares. For those interested in finding out more about this strategy, SIRCA has published a report on their research of this strategy in June 2011. This strategy was also covered in the ASX “Tax Effective Investing for Income” workshop which was held in Melbourne yesterday.
I have never been very comfortable with this strategy for a couple of reasons:
1) It involves holding the stock during the risky “confession” period when the company announces their half year earnings. If the earnings are good, the stock will normally rise in price (see price of ANZ on 30/4 in chart below), but if the earnings do not meet expectations it could also fall dramatically.
2) Stocks that pay high dividends normally fall in price after the stock goes ex-dividend (see price of ANZ in Nov 2012 and May 2013 in chart below). Hence, the dividend collected may be offset by realised capital loss when you sell the stock after 45 days.
To avoid the “earnings risk”, we could wait until earnings have been announced before buying the stock. However, the stock price can be very expensive, if earnings exceed expectation.
With high yield stocks like the Big 4 banks trading at multi-year highs, the “earnings risk” is quite high. Hence, I prefer to avoid holding these stocks during the “confession” period. My preferred strategy for getting income from these stocks is to:
1) Sell puts that expire before earnings announcement. With so many dividend hungry investors, the stock price tends to rise towards the dividend announcement period and my puts are likely to expire worthless.
2) If the earnings report is good, then sell puts again after the stock has gone ex-dividend. Although you will “miss out” on receiving the dividend and franking credits, the premiums from selling the two sets of puts will normally make up for it.
Below are some of the trades that I made on ANZ as an example of how this strategy works:
14/2 Sold April $28 puts for $0.83 cents when ANZ was trading at $28.
23/4 ANZ closed at $29.25 so my puts expired worthless
30/4 ANZ announced earnings and raised dividends. Share price shot up to $32
9/5 ANZ shares went ex-dividend, share price falls back to $30 after. Shareholders before this date would receive a total income of $1.04 (dividend of $0.73 with a franking credit of $0.31).
13/5 Sold ANZ June $30 puts for $0.58 when ANZ shares were trading at $30.12.
As ANZ interim results were very good, I expect the shares to go up or sideways, at least until the next earnings announcement in Oct/Nov. This means my June $30 puts would most likely expire worthless. Even if I do not get to own ANZ shares, I would have collected $1.41 from selling these two put options and the income received is more than the dividend and franking credit paid by ANZ. (Note: with the recent market volatility, ANZ shares are now trading below $30 so we may be assigned the shares in June).
In my humble opinion, selling puts is less risky than the “ex-dividend” strategy. If we buy the shares prior to the earnings announcement, there is a risk that the share price could take a big tumble if the earnings report is disappointing. If we wait until after the earnings have been announced, we may have to pay a high price for the stock if the earnings report is too good.
ANZ shareholders will have to wait until July 1 to collect their $0.73 dividend and wait until after they file their FY2013 tax returns to get their franking credits. In contrast, the income I have received from selling the put options are into my paid into my account as soon as I sell the puts. As I have not purchased any shares yet, the put premiums received, and the cash I have set aside to buy the ANZ shares will be generating interest in the bank while I wait for my June puts to expire.