Tapping the market for some extra cash in your pocket

Thursday, 31 January 2019
Melbourne, Australia
By Matt Hibbard

  • Something you can repeat over, and over
  • What you need to consider

Thanks again for joining me today here at Port Phillip Insider.

In case you missed yesterday’s edition, Bernd has kindly let me take the reins of Port Phillip Insider until his return late next week.

In the meantime, Sam will continue with his regular Friday spot, so please keep an eye on your inbox tomorrow for that.

Since sending out your edition yesterday, the markets have enjoyed a nice little bounce. Well, overseas, that is. Every financial site on the ether this morning was trumpeting the change in language from the Federal Reserve in the US.

Suffice to say, the Fed is beginning to back-pedal on the number — and timing — of potential interest rate rises.

While the Fed’s comments got all the coverage, it wasn’t the only reason markets jumped.

The very out of favour Facebook posted results that surprised everybody. And Boeing smashed its results from the same period last year, with a near 80% jump in earnings. What’s more, it is on track to deliver a record number of planes this year.

Only a few weeks ago, Apple’s CEO, Tim Cook, penned a letter to shareholders to inform them of a marked slowdown in iPhone sales to China. However, Apple shares also jumped overnight after it beat its revised earnings forecast.

Despite the strong impetus offshore, our own market barely got out of bed today. And even when it did, it was with a sore head. Mind you, the ASX has had a very good month…it needed to.

Over that time, the ASX has tracked the Dow Jones pretty tightly. To me, though, they are still very different markets. While some US stocks have missed expectations, such as Nvidia and Microsoft, others like those mentioned above continue to grow their cash pile.

By comparison, I see the rally in local shares as more of a catch up. That is, investors buying into stocks they believe are oversold — not because they think earnings are going to go through the roof. It is hard to see what could cause the Australian market to break out of its shackles.

I’ll discuss more about that, and how I think we should approach the markets, in Port Phillip Insider next week. For now, though, a quick look at the markets.

Markets

Overnight the Dow Jones Industrial Average closed up 434.90 points, or 1.77%.

The S&P 500 gained 41.05 points, or 1.55%.

In Europe, the Euro Stoxx 50 index finished up 8.32 points, or 0.26%.

Meanwhile, the FTSE 100 gained 1.58%, and Germany’s DAX lost 37.17 points, or 0.33%.

In Asian markets, Japan’s Nikkei 225 is up 262.14 points, or 0.31%. China’s CSI 300 is up 1.01%.

In Australia, the S&P/ASX 200 is down 5.2 points, or 0.088%.

On the commodities markets, West Texas Intermediate crude oil is US$54.66 per barrel. Brent crude is US$62.24 per barrel.

Turning to gold, the yellow metal is trading for US$1,319.98 (AU$1,816.50) per troy ounce. Silver is US$16.04 (AU$22.07) per troy ounce.

One bitcoin is worth US$3,444.88.

The Aussie dollar is worth 72.65 US cents.

Something you can repeat over, and over

In yesterday’s edition, I ran through how you or I can go into the markets whenever they are open, and generate income from options. I described it as money seemingly coming from the air.

If you recall, we used the example of Commonwealth Bank Ltd. [ASX:CBA]. In the example, CBA was trading at just under $71 ($70.94), and an April $71 call option would have traded for around $1.54. By writing one contract (at a $71 strike price), that would translate into $154 in premium for the option writer.

By writing that $71 call, you are locking yourself into selling CBA shares at $71, if the option is exercised.

However, you may not want to be exercised at $71. And that is where options are so flexible. You can always choose a higher or lower strike price, or one with an earlier or later expiry date. Each factor will determine the size of the premium you receive.

Options that have a low chance of exercise generate very little income. Those with a high chance of exercise generate a much higher premium.

Going into the market and generating premiums is something you can do again and again.

Take BHP Limited [ASX:BHP]. And please note that this is not a recommendation. At time of writing, you could buy shares at around $35. If you did, you could then write a call option with a $35 strike price and an April expiry for around $1.20. Meaning that if the option was exercised, you are in and out at the same share price, give or take a few cents. Yet that premium, $120 per contract, remains yours to keep.

Writing an option at the same, or similar, price to the entry price for the shares is called an at-the-money (ATM) option.

Likewise with Woodside Petroleum Ltd. [ASX:WPL]. And again, please note this is not a recommendation. With WPL, you could write an ATM option for around $1.10. If exercised, you would be in and out for around the same share price. However, again, that premium remains yours to keep.

What you need to consider

As I say, it can seem like free money. And in some ways, it is. You are capturing something inherent in all options, time decay, and putting it in your pocket.

But remember how yesterday I said that there were other things to consider before placing an options trade? Well, let’s take a look at them right now.

For a start, you only ever write a call option if you are prepared to hand over the shares at the strike price. If you are not, then don’t write a call option. You also have to be satisfied with the premium you receive, for the obligation you are taking on. If you don’t receive enough premium, then again, don’t take the trade.

And remember that it is an obligation. If you write a call option, and it is exercised, you must hand over the shares. While you can always buy the option back before expiry if you wish, once an option is exercised, you are locked into the trade.

That leads to perhaps the biggest rule in writing call options. That is, that you must own the stock before you write a call option. If you write a call option, but don’t own the shares, you are going to be left scrambling, and a long way out of pocket, if your option is exercised and you have to go into the market to buy the shares (to hand over). You can be sure your broker will charge you handsomely for any costs incurred.

And just a word on that. Even if you already own the shares before you write call options, always be sure to consider any tax implications. If you bought those shares a long time ago, and they have increased a lot in value, you could be up for some capital gains tax.

One other thing to remember is that while writing call options generates income, it does not protect you from a fall in the stock price. Sure, the premium you receive might help cushion the fall, but it’s unlikely it will mitigate the loss from a significant drop.

And on the other side of the equation, as I say, writing a call option obligates you to hand over your shares if the option is exercised. This can be particularly painful if the share price enjoys a nice rally. While you can always buy the option back (for more than you sold it), you might need to act fast, otherwise the option could be exercised and your shares will be gone. So you also need to be aware that writing a call option can put a cap on potential share gains.

Used appropriately, options can be a great way to spruce up your income.

I’ll now hand over to Sam for tomorrow’s edition. I’ll be back in touch next week.

Until then,

Matt Hibbard,
Editor, Options Trader