YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

Option Enhancement

One of the distinct aspects of YCG is our "Option Enhancement" component. This strategy involves the sale of put and call options to generate additional income and to enter and exit positions. We view the sale of put options as a way to be compensated to put in a limit order to buy a company we want to own, and the sale of a covered call as a way to be compensated to put in a limit order to sell a company already in the portfolio.

We employ this strategy opportunistically, selling a put or a call on a stock instead of purchasing it outright only if we believe the transaction both generates income and enhances our portfolio return. For example, suppose we're looking to make a purchase in a stock. We look at the premium we would pull in from the sale of a put a few months out and divide it by the notional value of that option. Then, we annualize that number, adjust for dividends, and tax effect it in order to determine an after-tax expected rate of return on the option. We then compare the expected return of the option versus the expected return of the underlying stock. If the expected return of the option is sufficiently greater, we'll write options against the cash we would've used to purchase the stock. Essentially, this cash is indirectly invested through a cash secured put. This process allows us to be much more objective, both in determining which stocks we are interested in, as well as when it is appropriate to be writers of options. We often find that the expected return on the options are greater than the expected return of the underlying stock.

Another advantage of this strategy is allowing us to convert short-term capital gains into long-term capital gains. In many cases, due to our long-term approach, premiums from the options will be converted from short-term to long-term capital gains, since both put and call premiums are treated as having an equivalent holding period to the underlying stock. This tax rule really benefits the investor when we want to sell a stock that has almost, but not quite, become a long term holding for tax purposes.

Overall, we believe “option enhancement” is a way to both to mitigate a value investor's bias of buying and selling early and to generate high after-tax returns with less risk.

We do not use this strategy as a means of generating implicit leverage. In other words, if all put option contracts were to be exercised, the fund will generally have enough cash on hand to purchase the assigned shares.

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