Performance Update for Colm Fagan's ARF

[ronaldo]

I'm interested in the tax side of the transaction but I'm trying to get my head straight on your proposal and strategy.

A big assumption is that the option side of the trade carries income tax treatment, but as you are assuming that, let's run with it for the sake of an example.

Let's assume a simple example - there are just 2 accounts: ARF A/C & OPTION A/C - and all we are seeking to do is understand the interaction of the accounts based on price movements and the tax implications following on from the price movements. Other trade iterations can be brought in later, but the strategy needs to stand up in its simplest form first.

Assumptions:
At time 'T':
Option position and type: Short an out-of-the-money (OTM) Call Option
S (share price): 100
X (exercise price): 110
P (option price): 1

Tax Rate of the individual: 25% (income tax plus USC)

Account Status at time T:
ARF A/C: Long one share valued @ 100
OPTION A/C: Short an OTM call option on the share with an exercise price of 110 and maturity T+1. Option seller receives the premium of 1.

At time 'T+1':
S: 150 (increase in price of the share of 50%)
X: 110
P: 40 (S-X)

Account Status at time T+1:
ARF A/C: Share is worth 150. Gross gain of 50.
OPTION A/C: Short option position is closed out by going long a call with same strike and maturity. Realised trading loss of 39 (premium received of 1 less 40 cost of offsetting option position).

Monies have to come across from ARF A/C to fund the cash shortfall in OPTION A/C. The share is sold in the ARF A/C. ARF A/C is long cash of 150.

To fund the OPTION A/C, 52 (39/(1-0.25)) needs to be taken from the ARF A/C. 39 is transferred to the OPTION A/C and 13 is paid in tax.

Is your net worth now in negative territory? +50 on the share, -39 option trading, -13 in tax, resulting in a net position of -2 (and worse if subject to a higher tax rate)?

Perhaps the strategy is to use the 39 loss ("trading loss") against your PAYE (income tax and USC) of 13 to put your net worth back in positive territory?

If you are using a trading loss against other income (a Section 381 loss), the full loss has to be used. 13 of the 39 loss can't be used against the PAYE tax of 13 with the balance carried forward to use in future years against the same trade (the trade of option trading). You would need to have scope to use the full 39 in the same year. The trading loss also can only offset income tax and not USC. In addition, if the trade is carried out in a non-active capacity, loss relief is not prevented, but it is limited (Section 381B), further crimping the potential utilisation (in a particular tax year).

Does the above broadly match what you have in mind? Have you gotten tax advice on the strategy?

The above figures look broadly accurate but are an outside case as 50% gains in 2 months are outside the norm.

This scenario of a small loss, but only if you were unable to offset the trading losses against other gains, may have been encountered had you followed the strategy at the wrong time with the likes of NVDA. However, also remember that if you aim for a 1% premium with a stock so volatile that 50% moves are possible, you end up going WAY out of the money. For example, shooting for a 1% premium with 2 months until expiry with NVDA today has you going 62.5% out of the money as opposed to the 12-15% you'd see with a typical stock.

The strategy definitely doesn't work well if all your positions were to rise 50%+ during the 2 month holding period and you were unable to offset the losses against other gains.

I do find that the bulk of options with premiums representing 1% of strike, and with 2 months remaining until expiry, will expire out of the money. On average, you would see the occasional one expire a little in-the-money but it'd be very rare to have anything expire as deep in-the-money as the above sample.

Continued use of the strategy would be monitored as the year progresses and it's much easier to continue if there are already profits that potential future losses can be offset against.

In short, the above is a risk but I don't believe the risk of a small loss encountered in such an extremely rare scenario would deter me from the strategy - even ignoring the potential of future gains making this particular trade net-positive again.

 

[letitroll]

An even more surprising statistic is that the value of the "low dividend" shares increased by 22.2% while the value of the "high dividend" shares fell by 2.2% in the half-year (a strange coincidence of "2"s!!). The pattern is reasonably consistent across the portfolio, with a small number of exceptions in both directions, of course.

Not a long enough period to be certain....but what your experiencing in terms of returns is what I would expect to see over the medium and long term of such a barbell portfolio of 'high dividend' and 'low dividend' stocks........much of the stock markets bond beating returns (over the long run)....comes from the power of retained earnings and their re-investment into incremental income producing opportunities with high returns on on that retained equity......it's this self-compounding mechanism which makes stocks a marvel when compared to bonds over the long pull.

The classic self-compounding stock is one with an optically high PE, low dividend.....but with high ROIC opportunities on retained profits.....and a long runway ahead of it of being able to deploy retained profits into incrementally high RoE opportunities - a classic 'compounder'.

Some stocks (high dividend/low PE ones) are almost like bond proxies....I suspect some of your holdings down 2.2% are a bit like..they likely send 80%+ of their annual profits out the door and retain very little...in some respects these companies are holding up their hands and saying hey we throw off alot of cash but we've no where to invest it sensibly so we are sending it to you as dividends so that you might do something better with it than we could. The subtext to that is that we dont plan to grow particlaury fast. The market prices them then with low growth...pays a low PE and as such then the dividend yield is also high.

Low dividend/high PE stocks......broadly......are the opposite....they are saying hey we've got lots of places to put retained profits at return rates you're unlikely to find elsewhere if you let us hold on to it......think of the returns on retained earnings that Novo Nordisk is getting on an investment of a new plant to produce GLP1's or ROIC on R&D to develop the next generation of GLP1's......I dont want them sending me dividends......I want them keeping the cash and building new factories...such that they are a much bigger business in years to come in terms of profits. The market anticipates their much larger future position and so will be pay a higher P/E today....on the expectation that E will be much larger in the future.

I'm still trying to get my head around it all. I wonder if there was a fashion in the half-year for "low dividend" shares to do well and "high dividend" ones to do less well. I don't know enough about investments to make a call. If it is a fashion, will high dividend shares come back in favour at some future date?

Yep fashion is good word for it.......some markets environments its all about 'jam tomorrow' (growth, EPS 5-10yrs out) and some market environments say like 2022 or 2000 or 2008 it quickly turns into a 'jam today' market.

Your high dividend stocks will outperform in jam today markets...and will underperform in jam tomorrow markets.

Right now we are in a market where stories about the future matter a lot....its most definitely a jam tomorrow market.

This is the push and pull of markets in the short run.......where sentiment matters a lot....and can whipsaw returns.

Over the very long pull...when you zoom out...stock returns are almost perfectly correlated and related to free cash flow per share growth or contraction.

 

[AAAContributor]

I do find that the bulk of options with premiums representing 1% of strike, and with 2 months remaining until expiry, will expire out of the money.

Are you executing trades in real-life or just in a test environment for now?

If in real-life, how are you currently accounting for tax with regard to the option premia?

 

[ronaldo]

If you can negotiate those sorts of charges, I take my hat off to you. I wish I could get anything close to that.

Apologies if I misled. Those are the charges the company for which I work in Northern Ireland have negotiated. I couldn't transfer my funds across to Ireland and expect anything similar to 0.19%, capped at £475, for platform charges.

I had been researching UK based SIPPS for some time but couldn't, until last week, find one that allowed non-residents to open them. You can continue trading with most as Irish-resident but cannot initially open it.

I found InvestEngine (link below) last week and they do allow non-residents to open an account. Their max annual charge is £200 but you can only trade ETF's. There are ETF's with Total Expense Rations as low as 0.03% so, in theory, your total expense on a £200,000 portfolio could be as low as 0.13% - or 0.08% for a £400,000 portfolio.

They do not allow transfers in yet which, given they are a new fintech company, gives me a chance to do my due diligence. They are regulated by the FCA but I don't think the savings of £275 in fees justify taking even the slightest risk.

I would be more tempted if I was paying the fees some Irish brokers charge and, when they open up for transfers in, it transpired that it was possible to transfer from an Irish pension to this product without exorbitant FX fees.

investengine

 

[ronaldo]

Are you executing trades in real-life or just in a test environment for now?

If in real-life, how are you currently accounting for tax with regard to the option premia?

I'm trading in real life, but not using a pension wrapper. I'm using a different strategy called 'The Options Wheel Strategy' which includes cash secured Put options and Covered Calls, all within an Interactive Brokers account.

Options premiums are treated as income tax and share holdings fall under the umbrella of Capital Gains Tax.

I have eight positions expiring tomorrow (seven cash secured puts and a covered call) with seven expiring out of the money and one, most likely, expiring in the money. That one is a cash secured Put 3.15% in-the-money at present. I will likely close that position and take the loss; offsetting it against existing gains. I do like the stock, as I do with any position I open, so will then consider selling puts for August expiry or purchasing the stock outright and selling covered calls.

 

[Gordon Gekko]

11.2% compounded over 13 years (11.92^13) is 397%

Which is a lot more than was contended by other posters…

 

[Colm Fagan]

Which is a lot more than was contended by other posters…

I don't know if I qualify as one of the "other posters". If so, I'll make the obvious point that I have been taking a regular (normally monthly) income from my ARF for the entire period since I started it thirteen and a half years ago. If I had left the full amount invested for the full period, it would clearly be worth a lot more.

 

[Gordon Gekko]

I don't know if I qualify as one of the "other posters". If so, I'll make the obvious point that I have been taking a regular (normally monthly) income from my ARF for the entire period since I started it thirteen and a half years ago. If I had left the full amount invested for the full period, it would clearly be worth a lot more.

Are your performance numbers ignoring the withdrawals?

 

[Colm Fagan]

They allow for withdrawals, of course.

 

[Duke of Marmalade]

Perhaps the strategy is to use the 39 loss ("trading loss") against your PAYE (income tax and USC) of 13 to put your net worth back in positive territory?

I must be misunderstanding this point. Would not 39 loss need to be set against 39 PAYE income to cancel the tax (I know not the USC). Mixing losses with tax seems to be apples with oranges.

 

[AAAContributor]

I must be misunderstanding this point. Would not 39 loss need to be set against 39 PAYE income to cancel the tax (I know not the USC). Mixing losses with tax seems to be apples with oranges.

You're correct Duke. That's where I went wrong. In my example the 39 option trading loss would be set against the PAYE income and not the tax.

 

[Duke of Marmalade]

@ronaldo very interested in your selling Covered Calls strategy. It is a bit the reverse of what you might think a typical investor's risk reward calculus would be. That would seem to be more satisfied by buying OTM PUT options.
We have had a long period of favourable stock performance so almost any strategy will work (except some Structured Products I am aware of ). Have you ever calculated your overall return on the strategy or compared it with where you would be if you had not applied the strategy?