How income from options could prove illusory

Funds that use call options to supplement dividends can offer higher yields, but this usually comes at the cost of lower long-term returns.

The outlook for income investors keeps getting bleaker. This week, soft-drinks maker Britvic became the latest company to delay its dividend, despite reporting solid profits. It’s not the biggest payer around, but it’s a good example of how companies are taking an exceptionally cautious approach and hoarding cash as much as possible in such uncertain times. 

The amount of dividends already skipped by UK companies comes to more than £30bn – and given that many of the largest payers have confirmed that they will be making reduced or no payments for the rest of this year, the final tally will be much worse. It’s difficult to imagine this rebounding quickly. So standard equity-income portfolios are likely to offer a lower yield even after the immediate crisis passes. And income-focused investment trusts that tap into reserves to maintain payouts are likely to find that cuts can only be postponed for so long.

Looking for a bit extra

Hence investors may be tempted to try to boost their income in other ways, such as via enhanced income funds. These combine a standard equity income portfolio with the use of options (see below). They follow a strategy called covered call writing, where the manager sells call options against stocks that they already hold to generate extra income via the premium they receive.

If the stocks don’t go up too much, this works nicely – the covered-call writer gets the extra premium income and holds onto their shares. But if stocks rises to the point where the option buyer exercises the option, the covered-call writer misses out on some of the capital gains. And since they have sold part of their portfolio, they must now reinvest the proceeds – possibly at a lower yield than before.

So while these strategies can deliver a higher initial income than dividends alone, it may come at the cost of lower longer-term returns. This need not always be the case: it will depend on the options-trading skill of the manager and also on the wider market conditions (covered-call writing should do better when markets range sideways).But where fund houses run both a standard income fund and an enhanced income version, the latter have mostly done worse in recent years. For example, the Schroder Income Fund has returned 48.7% over ten years, but the Schroder Income Maximiser has returned 36.9%. 

So in most cases, it’s wise to be sceptical about these funds. The income boost comes from sacrificing capital gains in a roundabout way and you are still exposed to the risk of dividend cuts. Investors who need more short-term income might do better to draw on their capital directly.

I wish I knew what an option was, but I’m too embarrassed to ask

An option is a contract that gives the buyer the right (but not the obligation) to buy an asset, such as a share, for an agreed price (the strike price), on or before a certain date (the expiration date). If the option gives the right to buy, it’s known as a call option; one that gives the right to sell is a put option.

The buyer pays an upfront fee – the premium – to the seller of the option (often referred to as the writer of the option). If the buyer exercises the option, the writer must sell them the underlying asset (for a call) or buy the asset from them (for a put) at the agreed price – they have no choice or opportunity for negotiation. If the buyer doesn’t choose to exercise the option, the writer has no further liability and has earned a profit from the premium.

An option where the current price of the asset means that it will be profitable for the buyer to exercise the option is said to be in the money. For a call option, this applies when the current price is greater than the strike price. For a put option, the current price must be less than the strike price. Options that would not currently be profitable are said to be out of the money. 

How close the current price of the asset is to the strike price is one of the key factors in determining the price of the option. Another is the volatility of the price of the asset: options on volatile assets will be more expensive and option prices tend to rise during market turmoil. The length of time remaining before an option expires is also important, with options that expire further into the future being more expensive. 

Options may be physically settled (the buyer and the writer exchange the asset in return for payment) or cash settled (one makes a cash payment to the other equal to the difference between the strike price and the current price of the asset). Options on individual shares are usually physically settled. Options based on something that is hard to deliver – eg, a stock index such as the FTSE 100 – will be cash settled.

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