How to use exchange-traded options in your SMSFPUBLISHED : | UPDATED:
More superannuationHow to find the best retirement vehicleCan someone’s debt be repaid by a transfer within an SMSF?Is it possible to retire with a geared property in your SMSF?What to do if something happens to a key member of an SMSFThe problems with buying property in your SMSF
A sophisticated taste ... exchange-traded options should only be used by experienced investors. Photo: Sahlan Hayes
- An exchange-traded option is a financial contract between two investors that is organised and monitored by a stock exchange such as the ASX
- The contract is a legal arrangement whereby one investor agrees to sell shares they own in 100 share lots to the other for a predetermined price
- Experienced option sellers can receive income on shares that can equal the dividend they receive. Popular option shares include the big banks and Telstra.
The sharemarket offers self-managed (or DIY) superannuation fund investors various ways of making money. For example, shares can be bought with the expectation of a price increase that will deliver a capital profit.
For a DIY super investor, the concessional tax rate that super attracts will lead to either 85 per cent of the gain after tax added to the fund’s wealth or 90 per cent if the shares were owned for more than 12 months before being sold.
Even better is a 100 per cent profit gain if the shares are sold after the fund has begun to pay all its member super pensions.
Shares can also pay dividends that are enhanced by tax credits available under the dividend imputation system. For a DIY fund with its 15 per cent or zero per cent tax rate (depending on whether it has started paying pensions to its members) a share paying a 5 per cent dividend can sharpen income by an extra 1 to 2 per cent thanks to the dividend tax credit.
More sophisticated investors can also gain either extra income or a combination of extra income plus a capital profit by offering to sell shares they own to other investors for a predetermined price. Such arrangements are more sophisticated because they require a detailed understanding of investments known as exchange-traded options.
Author and options adviser Wai-Yee Chen of broker RBS Morgans, says an exchange-traded option (ETO) is actually a financial contract between two investors that is organised and monitored by a stock exchange such as the Australian Securities Exchange.
The contract is a legal arrangement where one investor agrees to sell shares they own in 100 share lots to the other for a predetermined price. This offer to sell lasts for a certain period of time that can be a year or more but is generally three to six months.
The contract to sell involves not only a predetermined sale price but also an extra cost added by the seller for giving the buyer the right to acquire the shares. This extra cost is described as an option premium.
Experienced option sellers can receive income on shares that can equal the dividend they receive, Chen says. Popular option shares include the major banks, Telstra and other larger dividend-paying companies.
Exercising is a choice
A special aspect of ETOs is that the option seller must deliver their shares at the predetermined price if requested by the buyer during the contract period. The buyer has a choice of not exercising this right if the predetermined price they must pay before the option expires is greater than the market cost.
An option buyer in this instance can either let the option lapse or sell the right through the Australian Stock Exchange.
While the contract is in play, options have a tradeable value that is quoted on the ASX, which may or may not be worth more than what the buyer paid.
New tax regime
As far as the tax treatment of various aspects of options investing is concerned, this is topical as a result of the government’s plans to restrict how trading gains and losses should be treated. Under a revised tax regime that will apply from July 1, 2012, any losses on option trades can only be offset against capital gains.
This contrasts with widely held trading rules, where certain investors have been able to offset losses against current fund income such as interest income and dividend income.
A reader writes: “I read your recent report about the government changing the trading rules for DIY super (Portfolio, February 15, 2012). How will it affect the use of exchange-traded options as an income strategy?”
DIY fund investors can still use ETOs as part of an income strategy, says lawyer Bill Fuggle, a derivatives specialist with Baker & McKenzie.
But if they have been treating them as short-term trading investments in order to be able to claim any losses against general fund income, this won’t be available to them. Many experts believe these rules already apply to DIY funds.
This means if investors have no capital gains because they have not sold any investments at a capital profit during the financial year, the best they can do with option-related losses in a DIY fund is accumulate them for offset against gains in a future financial year.
Losses on options trading generally occur when option buyers sell out of their position at a price below the premium they paid.
While such profits have been treated as revenue by some investors, the treatment for a DIY fund investor will need to be along capital profit lines.
This means no immediate deduction for the cost of the option. Instead the option premium cost can only be added to the cost of the shares establishing a higher cost price in the capital gains calculations that apply when the shares are sold.
As far as the tax treatment of a profit made by option sellers who make extra income by offering investors the right to buy their shares, if the option is not exercised the premium received by the DIY fund is taxed as capital income.
If the shares are delivered as a result of the option’s transaction, the option premium income is added to the sale price of the shares.
Follow us on Facebook and Twitter
John Wasiliev Smart Investor