Once we have conducted our fundamental research on the stocks we want to own, we may seek to enhance the Fund’s returns through the sale of cash secured puts and covered calls. This could be viewed as being compensated to place limit buy and sell orders, thus potentially generating additional income while entering and exiting positions. Though, after the first option period has concluded, we may continue to write options, believing they could potentially be more profitable than owning the underlying stock. In other words, it’s possible that the sum of premium income received from constantly writing options could exceed the actual price appreciation of the stock itself. This is because, just as stock investors tend to gravitate towards riskier stocks for a quick pay-off, this casino mentality spills over into the options markets where investors generally overpay for stock options due to their ostensibly attractive asymmetric payoffs. Thus, we view ourselves as “the house” by selling put options on securities we want to own and selling covered calls on securities we want to sell and allowing others to gamble in the options.
However, unlike some options strategies, we do not mechanically write options on all our positions. Before choosing whether to express our investment directly through stock ownership or indirectly through options, we calculate a forward expected rate of return for the underlying stock and for the option and compare the two rates of returns. If the spread is wide enough to provide what may potentially be a higher rate of return in the option, then we may choose to write options against the cash we would have used to purchase the stock outright. Essentially, this cash would now be indirectly invested through a cash secured put. These calculations allow us to objectively determine when it is appropriate to be writers of options.
Importantly, we will not use this strategy as a means of generating implicit leverage. In other words, if all put options were to be exercised, we will generally have enough cash on hand to purchase the assigned shares. Thus, we view this as a potentially risk reducing, yet potentially return enhancing, strategy.
There are also potential tax benefits to this strategy:
- When options are assigned to us, the premiums, which could have been treated as short-term capital gains, are now imbedded in the cost basis of the stock purchase and that income will be treated according to the holding period of the stock. Since we are long-term investors, it is likely that the short-term premium income will one day become long-term capital gains.
- If options are not assigned to us, this generates short-term income. However, the IRS rules of a mutual fund allow short-term income to be netted against the fees and expenses of a fund. This means much of the premium income, if not all, will essentially be converted from short-term income into qualified dividends. This can be seen by looking at our “Historical Fund Distributions” report.
- If we write a covered call and it is called away, the short-term premium income is added to the sales price of the underlying stock and treated as having an equivalent holding period to the underlying stock. Since we are long-term investors, this means it is likely that the short-term premium income will be converted to long-term capital gains. If we wrote this covered call on a stock that was short-term, but then over the waiting period the stock goes long-term, both the stock and the option convert from short-term to long-term capital gains and could potentially defer all of these gains into the following tax year if this strategy is utilized at the end of year.
Overall, we believe “option enhancement” is a way to both mitigate a value investor’s bias of buying and selling early and potentially generate high after-tax returns with less risk.
All index and financial terms, definitions, and acronyms can be found on our Glossary page.
Nothing contained on this communication constitutes tax, legal, or investment advice. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation.