With financial markets in turmoil and volatility levels at heights not seen for many years, the common folk believe the share market is a scary place to be invested in right now. However, through some simple research, I personally believe it is the best place for your money to be invested. This article is going to uncover how you as a trader can benefit from trading shares that pay solid dividends. My previous article, Dissecting Dividends, explained the basics of what a dividend is and dispelled the common myth that easy money can be made by trading a share when it goes ex-dividend. Readers may wish to review this article as it will provide an explanation for some of the terms covered below.

The Australian Prime Minister Kevin Rudd announced in October that bank deposits would be guaranteed for at least three years. This has resulted in investors pouring their money out of shares, commodities, property and retirement investments into savings accounts at banks. These savings accounts are currently paying an interest rate of ~6.1%pa. Good deal right? Not necessarily so!

Any interest earnings from a saving account is assessable income for taxation purposes. Most Australians pay $0.30 in the dollar in tax. Therefore the interest earned after tax equates to 4.27% (30% of 6.1%). Readers may still be thinking this is a solid return due to the fact there is no risk. Not the case!

(Note: as of this writing, the US/AU dollar currency conversion rate is $1 US to AU $1.5855).

The Reserve Bank of Australia [RBA] announced on October 23 this year the current inflation rate is 5%. This Consumer Price Index figure [CPI] tells us that an item costing $1 a year ago will cost $1.05 today. Recall from above that having your money in a savings account with an interest rate of 6.1% compromises to an after tax rate of 4.27%. Now, factoring in inflation, your net return is -0.73% (4.27% - 5%). That’s right, after one year you have actually lost money!

Table 1, below, illustrates this using an account balance of $10,000.

The above explanation may seem long winded, but it is imperative people understand what is really happening. Now that savings (cash) has been covered, let’s take a look at dividends and options.

From Dissecting Dividends it is understood that options are perfectly priced. How then can trading a dividend paying share create the opportunity for a healthy-limited risk income stream? The answer for Australians (USA residents to a lesser extent) lies in the taxation laws. Companies in Australia pay a flat rate company tax of 30% on assessable earnings. In most cases the dividend is paid with after tax dollars. To avoid double taxation the Australian Tax Office [ATO] allows Australian residents with Australian shares to receive a 30% tax imputation credit if, after tax money, it has been used to pay the dividend.

To illustrate I will use the Australian Bank, ANZ. The annual dividend received by shareholders is $1.36. This is paid out of after tax earnings. When reporting dividend income in a person tax return they must disclose the unfranked amount of $1.94 per share and then claim the $0.58 as a deduction. Table 2 shows the calculation involved.

Table 2 – ANZ dividend broken down

Table 3 illustrates that $10,000 on October 24 would have purchased 555 ANZ shares and these are expected to pay a franked dividend of $755 over the next year.

Table 3 – ANZ shares with a dividend yield of 7.55%

Since the shares are fully franked the tax owing on the dividend income (say 30% to be consistent with the savings account scenario) is directly offset by the imputation credits.

There are a couple of important assumptions I have made that you need to be aware of:

1. The share price will be the same in a years' time after inflation is taken into consideration. Please be aware shares are a hedge against inflation.
2. The dividend will remain the same for the coming year as it has for the past year.

Point number one is a bold assumption. The share price is very unlikely to be the same as it is today. This is where options can be used to create the buy-write strategy also known as collar trade. Through buying a protective put and simultaneously selling a call to pay for the put a trader can lock in the share price. Not a bad idea with the Implied Volatility [IV] and Statistical Volatility [SV] so high. It will give you peace of mind. After all, I am talking about placing your savings in the share market as opposed to a bank account!

Some companies give shareholders the option of reinvesting their dividends or to have the money deposited to their account. I would suggest you do not directly reinvest your dividends through buying more shares as this will upset your hedge. Rather use the dividend payment combined with personal savings to purchase more shares in 1,000 lots. This will allow you to buy/sell further options and hence maintain completely hedged.

As for assumption number 2, ANZ announced earnings in October 2008. After tax, profit fell by 21% to $3.3 billion. Yes, they are still making money—just like all of the big Aussie banks. The $1.36 fully franked, full-year dividend was reaffirmed and growth is expected for the coming year.

The shares I own (including ANZ) are for the long term and I continue to buy more, irrespective of the share price. If you are using options to hedge then it doesn’t matter what happens with the price. Naturally you can adjust the aggressiveness of your collar when the market settles down and a young calf (bull) emerges. This probably won’t be for a year or two yet. As long as the dividend keeps coming in, I am happy!

Table 4 includes some of our blue chip shares. It is highly likely that these companies will still be around in 5, 10, 20… years' time as they are the backbone of the Australian economy. Each of these companies pays a solid dividend (fully franked) and have options available.

Table 4 – Blue chip Australian companies and dividend amount

The upcoming 2-Day Seminars across Australia, which will see out 2008, will explore dividends and how you can use them so that your money works for you. The special Alumni-only seminar in Adelaide on December 6-7^th is set to take your trading to an extra level. Many of the basics usually covered in-depth will be skimmed over so that the more advanced topics may be expanded.

Make it happen!

Guy Halpin
Senior Writer & Options Strategist
Optionetics.com.au ~ Your Options Education Site