Collecting option premium to enhance yield

As the global stock of negative-yielding fixed income instruments is back to its highs of $12 trillion and the US 10-year government bond yield hovers close to an 18-month low, the “search for yield” is still very much on.

Yield enhancers

In the equity space, the obvious way to generate additional income is by buying high-dividend yielding stocks. Yet, as we have argued previously, the higher the dividend, the more likely it is to be cut. For this reason, our focus remains primarily on companies offering dividend sustainability and growth potential with a particular attention to free cash flow.

However when trying to enhance yield, we encourage investors to consider alternative strategies to dividend income. At a time when future returns may be more muted, we think one strategy stands out: selling options, and specifically “put” options on owned stock in order to collect regular premiums¹.

Option premiums

In many ways, collecting option premiums is equivalent to taking the role of an insurer: collecting premiums and, from time to time, paying back claims. Of course, insuring someone or something is not without risks. But when done diligently, it can be rewarding. In the world of equities, we believe investors should follow these three rules to maximise their chances of success:

1. Balance the risk and reward appropriately. Insuring someone for the smallest drop in equity markets may yield a significant premium but the probability of claims being made is commensurably higher. We believe that a cushion of around 4 to 5% is more appropriate for a strategy that is, in essence, designed to be relatively defensive.
   
   
2. Prefer short-term contracts.  While the likelihood of a drop in equity markets is higher over a short period of time than it is over many years, a short-term contract (say two weeks) provides the opportunity to renegotiate the premiums more frequently, allowing potentially higher premium income.
   
   
3. Be systematic. The old adage that “it is time in the market and not timing the market” is also true for options strategies. By transacting systematically (for instance every week), you can take advantage of spikes in volatility to collect higher premiums without the need to worry about timing.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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