In trades where you will only be holding the stock for it's dividend and then selling, doubling that dividend is the best method because future and past dividends are irrelevant. While 5% may not seem like a lot, this does not include franking credits that improve the after tax return.

A fully franked dividend yielding 5% equates to a 7.14% yield when franking credits are taken into account, and higher still if the marginal tax rate of the investor is below 30%.

In the first example above we were given a value of $ 30.00 for NAB. At this price, NAB will meet the 19-second rule. This means, if we want to consider buying NAB as a positively geared investment, it must be at a price of $ 30.00 or lower.

You might ask: "but what if it never gets that low?" I am about to show you how you can make money from NAB whether it falls to $ 30.00 or not.

The first step is to 'sign a contract' that we will buy NAB at $ 30.00 if it gets there. For this, we will be paid on average 40c a share every month (price estimated and irregular) until NAB hits $ 30.00, or until NAB rises far above $ 30.00.

We do this buy 'writing' a put option. We make an agreement with another party, that we will buy their NAB shares off them for $ 30.00 if NAB falls below this price, and IF they decide to exercise their option. In practice they will not exercise their option unless there is a financial incentive for doing so.

This means that we usually will not have to buy the shares until the expiry date. The party that buys this contract from us, does so because they wish to profit from NAB falling in price, should it happen. They may be speculating, or hedging their shares against the risk of a sharp fall.

Lets pretend it is January 3rd, and NAB is trading at $ 31.50. We have used the 19-second rule, and wish to buy 10,000 NAB at $ 30.00. We are prepared to wait as long as is necessary. We determine that we need to write a January $ 30.00 put, and manage to sell 10 contracts for 19c each. We receive 19 x 10 x 1000 = $ 1,900 in premiums. January expiry day comes and goes, just as NAB hits $ 30.50.

Having kept all of the $ 1,900, we write some February contracts for 34c. We receive 34 x 10 x 1000 = $ 3,400 in premiums. Expiry day comes around, and NAB is trading at $ 30.12. The puts expire worthless. Having kept all of the $ 3,400, we write some March contracts for 62c. We receive 62 x 10 x 1000 = $ 6,200 in premiums. Expiry day comes around, and NAB is trading at $ 29.88.

The put buyer exercises his options, and we buy 10,000 NAB @ $ 30.00.

Our purchase looks as follows:

Jan - received $ 1,900 - balance = $ 1,900
Feb - received $ 3,400 - balance = $ 5,300
Mar - received $ 6,200 - balance = $ 11,500
Mar - bought 10,000 NAB @ $ 30.00 = ($ 300,000) - Balance = ($ 288,500)

Our average buy price for NAB is $ 288,500 / 10,000 = $ 28.85.

Note that this is even less than the price we were prepared to pay, and is still less than the current market value of $ 29.88.

We have in effect, bought NAB at a great discount:

Original price - $ 31.50
Effective buy price - $ 28.85
Discount = 8.4%

Furthermore, we have made a profit because NAB is trading above our effective buy price:

Current price - $ 29.88
Effective buy price - $ 28.85

Profit = 103c / share x 10,000 shares = $ 10,300 or 3.6% gain
 

Had we bought at $ 31.50, we would now be down 8.4%. Instead, we are in profit by 3.6%. Our total performance is therefore improved by 8.4% + 3.6% = 12%. We have in effect bought NAB at 12% below market price. If we choose to sell at $ 29.88 we also take a capital loss on paper, as we paid $ 30.00 and sold for $ 29.88. Had it taken longer to reach $ 30.00, we would have been able to write puts for later months, which would have reduced our effective buy price even lower.

You can think of this strategy as a 'lay-by' for shares, where you also get to buy the item on special at any time during the lay-by period. We did not own the shares for 3 months of the year, so it is possible we missed out on a dividend. In effect we missed out on half of a dividend, because they are paid every 6 months.

It was not necessary for NAB to fall. Had it drifted sideways for 6 months, a similar result would have been obtained. Whether or not NAB reaches $ 30.00 is irrelevant because we have already banked the income from the put options. This strategy should be used when the investor wishes to purchase actual shares. You can use the strategy with no intention to actually buy shares, but be warned if you are exercised you must buy the shares and sell them again, which may cost big money in brokerage.

It is not a risk-free strategy, as a large fall in the stock to say $ 30.00 would still leave the investor in a position where they must pay $ 30.00 per share. It is however less risky than buying the shares outright as a normal investor would do, because our risk starts at the $ 30.00 level, not the $ 31.50 level, and as I have shown it is a more economical option.

Note: Writing options requires a margin to be met.

With a rental property, assuming no vacancies and a fortnightly rent income, there is a very consistent, even, predictable flow of income. Buyers of property will not be concerned with when the rent is due next, because at worst they will miss out on 13 days income, which is a fairly small amount in comparison to the purchase cost of the property.

With shares however, income is distributed much less frequently, less evenly, and less predictably. While this may sound like a negative, once you are aware of this inefficiency, you can exploit it. When an investor buys a share, the difference in effective purchase cost is influenced to a much greater degree when dividends are taken into account.

Example:

Investor A buys a .00 share which paid out a 50c dividend the day before he bought.
Investor B buys a .00 share that pays out a 50c dividend the day he bought.

Investor A has to wait another 6 months before he receives any income from his investment, and again in a further 6 months. This means that over a 365-day period, he receives 2 dividend payments. The average investor would expect this, and would not consider that there is a better option.

Investor B gets a return on his investment after only one day, plus he receives another payment in 6 months time, and again in a further 6 months. This means that over a 366 day period, he receives not two but three dividend payments. His effective purchase price is .29 (.00 less 50c dividend and 21c franking credit)

Investor A invests for 365 days and receives two dividends, or $1.00 per share. His net dividend yield is 100/3000 = 3.33%

Investor B invests for 366 days and receives three dividends, or $1.50 per share. His net dividend yield is 150/3000 = 5%

Investor B invests for 0.27% longer (366 days Vs 365), but his dividend yield is a 50% increase on that of Investor A (5% Vs 3.33%).

Had both investors bought instalment warrants instead of shares, they may have found that the returns were 10% for Investor A and 15% for Investor B, quite possibly the difference between a positive geared scenario and a negative geared one.

To put this in rental property terms, Investor A bought a house expecting and receiving the normal fortnightly rent, while Investor B bought a house which included six months rent in arrears. Naturally this would never happen with property, but it happens frequently with shares. The timing of a share purchase can make a big difference to the return produced and the effective purchase price. Be sure to allow for dividends when you consider investing in equities.

Worked Example:

This strategy involves buying stock or instalment warrants shortly before a dividend is paid, and holding it for just over 12 months. Over this period three dividends will be received, and any capital gains after 12 months will be taxable at half the normal rate. This means that a dividend with a yield of 5% can be purchased on margin and made to produce 7.5%, in effect creating a positively geared investment.

CBA pays a 65c dividend on the 10^th of May. On the 9^th of May, CBA is trading at $ 26.50. David buys 10,000 CBA shares on margin, costing him $ 79,500 (30% margin). Three weeks later he receives a dividend cheque for $ 6,500, and prepays some of the interest on his margin loan. Based on a rate of 7.5% on $ 185,500, the interest bill for 12 months will be $ 13,912.50. Paying $ 6,500 before June 30 provides additional tax benefits for that financial year.

This is called deferment, it is not a 'saving' as some claim, but merely a way of nominating the year in which you make the claim. It may be better to claim the deduction in a year where there are higher capital gains than are expected for the following year.

Six months later, another $ 6,500 dividend is received, which is transferred towards the margin loan. By this stage, $ 13,000 has been paid, which is the majority of the interest amount. The margin lender will probably provide some incentive for prepayment. Another six months pass, and a $ 7,500 dividend cheque arrives (dividend growth over time is to be expected). By this time, CBA has risen to $ 30.00, and David decides to take the money and run.

Bought 10,000 CBA @ $ 26.50

Purchase Cost - $ 265,000

Margin Amount (30%) - $ 79,500

Borrowed Amount - $ 185,500

Interest Rate = 7.5%

Interest Cost - $ 13,912.50

Discount for Prepayment = $ 927 (0.5% discount)

Dividends Received = $ 6,500 + $ 6,500 + $ 7,500 = $ 20,500

Franking Credits received = $ 20,500 x 0.4285 = $ 8,784

Net cashflow

= dividends - interest + prepayment discount = $ 7,515

David sells 10,000 CBA @ $ 30.00 = $ 300,000

Capital Gain = sell price - purchase price - interest cost (interest is deductible)

= $ 300,000 - $ 265,000 - $ 13,912.50 = $ 21,087.50

Brokerage costs = 0.09% x $ 265,000 + 0.09% x $ 300,000

= $ 238.50 + $ 270

= $ 508.50

Gross profits = capital gain + dividends + franking credits

= $ 21,087.50 + $ 20,500 + $ 8,784

= $ 50,371.50

Cash on cash return = gross profit / total outlay

= $ 50,371.50 / ($ 79,500 + $ 508.50)

= 62.95%

This is a stunning return and highlights how positive gearing together with the benefits of franking credits and the 12-month capital gains tax rule can outperform most investments with ease. David did not have to sell, his investment is positively geared so he would be silly to.

This example is for demonstration purposes only and is not intended as a recommendation or advice.

On very rare occasions, a company will provide a special incentive to shareholders for handing back their shares. It usually occurs several years after the company is floated, and the company knows that there will be a lot of people afraid to sell, because the share price may have gone up which means capital gains tax.

To overcome this investor fear, the company will restructure the buyback so that capital gains tax is avoided. It often involves providing a share buyback at the original float price, and a fully franked dividend covering the remainder.

Example:

RYN Ltd floated 2 years ago at $ 2.00

Their share price is now $ 3.50

For a buyback, they offer a capital component of  $ 2.00 a share, plus a fully franked dividend of $ 1.50 per share. This means that shareholders from the float can avoid capital gains tax, plus get a heap of franking credits to use this year:

Buy price = $ 2.00

Sell price = $ 2.00

Capital Gains = $ 0

Dividends = $ 1.50

Franking Credits = $ 1.50 x 0.4285 = $ 0.64

Total gross dividends =  $ 2.14

Add capital component = $ 2.00

Total Payout =  $ 4.14

Not only do the shareholders receive an extra 16% premium for their shares, they avoid all capital gains as well. An added bonus using this method is that it appeals to the Australian shareholders more than overseas investors.

Foreigners cannot access franking credits so they will be less likely to take up the offer. The method rewards loyal Australian shareholders. However, if you are well organised and buy shares before the record date, then complete the necessary paperwork and wait the required period, you can get even more benefit because you can also claim a capital loss:

Buy price =  $ 3.50

Sell price =  $ 2.00

Capital loss = $ 1.50

Tax saving = $ 0.45*

Gross Dividends = $ 2.14

Capital component = $ 2.00

Total Effective Payout =  $ 4.59

 Recently Telstra made such a buyback offer, which was a great opportunity for existing and new investors. Since then however, the ATO has decided to crack down on the practice because of a fall in tax revenue, and in future such opportunities may not be so abundant, but nothing has been confirmed as yet.