Learn how to build income streams from your existing shares, in addition to dividends.

Many investors are still searching for attractive dividend yields, knowing that past dividend payouts may not achieved in the future. They might be reluctant to sell shares that have traditionally been great dividend payers and had the added bonus of franking credits. 

One certainty is that everyone is keen to get some return from their portfolios, especially while the sharemarket continues to trend sideways.

Options and income investing

The options market offers strategies that can reduce risk in a share portfolio and provide an income stream over and above dividends. The most popular of these strategies is the covered call.

The covered call is essentially a strategy for neutral markets and is one of the few ways an investor can generate returns when share prices are moving sideways. It involves selling call options on shares that you own, and thus agreeing to sell shares at a higher price in the future. 

For this agreement you receive a premium, almost like an extra dividend on a shareholding. If the share price remains steady, you get to the keep the premium and the stock. 

Typically the strategy is constructed using options with 1-2 month timeframe. 

Example 

The Commonwealth Bank (ASX:CBA) traded at $68.50 (at the time of writing this article) and had a high in August of $74. By selling an option you agree to sell 100 shares per contract at $74 within the next two months. 

For this agreement, you could receive $0.90 cents per share or $90 per contract regardless of where CBA’s share price moves. That’s a handy income stream if you could repeat it every two months, as it would total $5.40 in additional income over and above CBA dividends per year.  

Let’s say CBA’s share price remains below $74 and the option is not exercised. You would keep the premium income ($90) and the shares. 

In comparison, a shareholder who has not written options has derived no benefit from their shareholding during this period.

If the share price at expiry is above $74, the option will be exercised, and you must sell the CBA at $74. This obligation applies regardless of how far above the exercise price the stock has risen. 

The effective sale price, however, is $74.90 (the $74 strike price plus the $0.90 premium).

There are two key risks with the covered call strategy:

1. The stock continues to fall – if the share price slumps, the fall in the stock’s value may exceed the premium received. If CBA fell below $67.60, you would make a loss.
   
2. The stock rallies strongly – as the call writer you, are obligated to sell stock and therefore give up any additional profits above the strike. If CBA rallied beyond $74.90, you would have been better off not writing the covered call. 
   

Thus, using covered calls can potentially reduce the risk of a share falling, while also providing an income stream.