Benoît Poliquin, CFP, CFA – President and Lead Portfolio Manager Option Strategies for your Portfolio

RAISON D’ÊTRE

Issues facing investors today Low interest rates have increased the need for income. Need more capital for same level of income. Markets have been volatile and have not offered dependable capital growth opportunities. Makes for difficult long term decisions. Underlying global economy does not provide for stellar environment for companies. What will provide better returns for investors in the future?

THE SOLUTION IS…

Owning Quality Assets Stock Market are volatile. Expectations and economic events are unpredictable. ≠ Your spending needs are certain. Most investors sell low and buy high. Humans are pre-wired to seek out the safety of crowds… Performance chasing

Owning a business Imagine you owned a business: Where the brand name was established Proven Management Profitable Dividends increased every year Would you invest?

What if… Every day, someone can quote you a price on this business. Would you always own it? Would you be worried if were offered 30% less than what you paid? Would you be offended or exited?

For Example : Johnson & Johnson At first glance, stock price is disappointing…$10 in growth in 10 years But better than the market JNJ +22% S7P 11% However Dividend from $0.18 in Q2 01 to $.57 in Q2 11 = 3X Earnings Per Share 2001=$1.75 / 2010=4.78 Quality Matters Boring…but profitable!

What if.. You invested in companies with these characteristics. You were disciplined on purchase price & and your sale price. You get a bid every day Take advantage of irrational investors Always earning dividend income. Growing Tax efficient (Canadian Corporations) Passive…your money working for you

YES, BUT CAN I MAKE MORE?

OPTION STRATEGIES CAN HELP…

Options Basics: An equity option is the right but not the obligation to Buy (Sell) at a specified price (strike price) by a certain a date. They are listed just like a stock…trade them in a similar fashion. Option Prices are influenced by: Underlying share price. Time until expiration of the option. Volatility (how much the price varies over time). Interest Rates. Dividends.

Option Types: A Call Option allows the holder/buyer to purchase the shares at a future price by a specified expiration date. You can buy a call option You can sell or write a call option A Put Option allows the holder/buyer to sell the shares at a future price by a specified expiration date. You can buy a put option You can sell or write a put option

PUTTING IT ALL TOGETHER

Step One: Quality Assemble a portfolio of companies domiciled in Canada and abroad with the following characteristics: An ability, a history and a policy of paying ever growing dividends to shareholders Operate in profitable industries Sound management

Step 2: Research Determine the fair market value: Based on historical valuation (ie: P/E ratios, BV ratios) In relation to the company itself In relation to the broad equity market (TSX, S/P 500,etc.) In relation to the price of money/interest rates Determine entry points: Based on fair market value research Technical analysis

Step 3: Option Research Determine appropriate strike prices for call to be sold. & select ideal date of expiration Determine appropriate strike prices for put writing. Ensure sufficient cash component for the underlying commitment to purchase Select ideal date of expiration

LIVE EXAMPLES

Example #1: JNJ (ignoring transaction costs) Stock Price = $64.08 Assume stock is purchase at this price; Sell call (Oct 22/2011 expiry) for $0.64 & Strike= $67.50 Your net investment is $ = $63.44 Probability of being exercised ≈ 31% If JNJ trades for more than $67.50, call option in the money If exercised, investor strike, for a profit of $4.06 ($ $64.08+$0.64) or 6.4% Profit of 6.4% in 49 days Investor can repeat 7 times in the year If JNJ trades below $67.50, investor keeps premium Repeat process upon expiration of call option

Ramifications If investor has many choices; Can buy back call (at a loss) and keep JNJ Keep profit and… Investor can sell put against proceeds at a lower price Investor can invest in another company and repeat the covered call exercise. Benefits: Higher cash flow = consistent return Disciplined sell and purchase prices But Upside is capped to $4.09 for 49 days

JNJ conclusion- Securitized Puts Investor was “called away” from JNJ and sold at $67.50 Investor would like to reinvest in Can wait in cash until this price is reached in the market Investor can could sell $65 put and securitize the commitment to purchase with cash Sell put $65 and collect ≈ $3.25 Commitment to buy $65 in 50 days is set aside If JNJ trades down to $65, put should get exercised at net cost is $61.75 to invest in JNJ If JNJ stays above, $65, simply repeat with new put option

Example #2: RY (ignoring transaction costs) Stock Price = $48.93 Assume stock is purchase at this price; Sell call (Oct 22/2011 exp) for $.35 & Strike= $55 Your net investment is $ = $48.58 Probability of being exercised ≈ 14% If RY trades for more than $55, call option in the money If exercised, investor strike, for a profit of $6.42 ($55-$48.93+$0.35) or 13% Profit of 13% in 49 days Investor can repeat 7 times in the year If RY trades below $55, investor keeps premium Repeat process upon expiration of call option In this case, a $.54 dividend is payable on Oct 22, adding to the potential profit

Ramifications If investor has many choices; Can buy back call (at a loss) and keep RY Keep profit and… Investor can sell put against proceeds at a lower price Investor can invest in another company and repeat the covered call exercise Benefits Higher cash flow = consistent return Disciplined sell and purchase prices But Upside is capped to $6.42 for 49 days

RY conclusion-Securitized Puts Investor was “called away” from RY and sold at $55 Investor would like to reinvest in 50 Can wait in cash until this price is reached in the market Investor can could sell $50 put and securitize the commitment Sell put $50 and collect ≈ $3.50 Commitment to buy $55 in 50 days is set aside If RY trades down to $55, put should get exercised at net cost is $51.50 ($55-$3.50) to invest in JNJ If JNJ stays above, $55, simply repeat with new put option

PUTTING IT ALL TOGETHER

Net Result = Higher Cash Flow Capital growth will stem from higher valuation of companies and tends to ebb and flow with investor sentiment. The covered call + securitized put strategy harnesses this volatility and converts into higher income at the expense of limiting violent upward movements in stocks and the onset of additional transactions. The additional income is a buffer for investors, and can be used for day to day expenses Strong discipline is ensured by the implicit pre determined sell and buy targets.

Quality Remains Investors still owns a portfolio of quality companies ≈30 stock positions Growing dividend income stream Diversified by country and geography Options is a profitable to harness volatility Using daily price changes as an asset instead of a liability Increase the cash flow of the portfolio

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