The Galaxy Dividend Income Growth Fund’s Option

Investment Strategies
FM1 Assignment

Ashlesh Mangrulkar
B18014 (Section A)
08-OCTOBER-2018

Name : Ashlesh Mangrulkar SID: B18014 Section A

 Introduction
The Galaxy Dividend Income Growth Fund is a closed end mutual fund (funds
listed on the stock exchange and traded throughout the day) offering
investment opportunities to different institutions in the US.
The fund has traditionally generated income through 2 primary routes :
a.) Investing at least 75% of its total assets in the equities of firms that paid
dividends to its existing shareholders, planned to increase the dividend payout
and had the capability to undergo capital appreciation.
b.) Invest in equities that at present were not paying dividends to their
shareholders, but near term growth potential was bright and would eventually
pay out dividends in the long run.
The Fund has paid dividends of $0.40 annually per share even when returns
have been negative. To meet this, it has even recommended cash distributions
that exceeded income generated through some return of capital.
The management has proposed that the Fund can engage in options trading.
The directors have requested for a pilot study of potential profit and losses
from selective options trading. Two stocks in the fund’s portfolio : JPMorgan
Chase & Co. and Facebook, Inc. have been selected for the study.

Name : Ashlesh Mangrulkar SID: B18014 Section A

 Financial Problems
1. Low Yield financial environment since the 2008 financial crisis has
affected the traditional investment returns for the Fund.
The Fund has found it increasing difficult to meet its level cash dividend
policy of $0.40 per share annually. It has even recommended payouts that
have exceeded its net investment income resulting in return of capital. The
Fund has to decide on an options strategy to boost its incomes by buying
options or by earning premiums by selling or writing options. The Fund is
already being traded at a discount of 12% from its NAV. It has $1.25 billion
in assets and 117 million shares, resulting in NAV of $10.68.
2. Analyzing volatility of underlying asset and rigid dividend policy
The Fund has a policy of giving out dividend of $0.40 annually since its
inception. Despite factoring market volatilities and fluctuations it hasn’t
historically deviated from its performance. This creates a stress on asset
value and fund managers are pressurized to generate high returns which
can be difficult in bearish market. The Fund had to resort to using its capital
to sustain the policy. An alternative to exploring new investment channels
can be to make dividends a function of market movement. Through
derivatives trading, the Fund is increasing its exposure to the volatility of
the stock prices. In volatile markets, writing an option becomes more
attractive than buying options.

3. Calculating risk/reward payoff which is dependent on risk appetite.

Each options strategy has an associated payoff. Conservative investors, for
example, do not invest in naked calls ( writing call options without owning
the underlying security) and invest in covered calls. Depending on the stock
biases we might go bullish, bearish or neutral. The Fund traditionally has
shown a preference in companies that pay dividends to shareholders. In the
case, we have 2 companies, JPMorgan Chase & Co. that has historically paid
dividends and Facebook, Inc. that has a higher P/E ratio.

Name : Ashlesh Mangrulkar SID: B18014 Section A

 4. Deciding on an options strategy for the Fund for generating higher risk
adjusted returns through returns and premiums.
There are 2 key aspects when trading options on stocks : strike price and
maturity time period. To be able to calculate future payoffs the Fund
should be able to predict with reasonable accuracy the share price on
maturity of JPMorgan Chase & Co. and Facebook, Inc. The options
premium will be decided by the maturity period. There is also an
opportunity to generate returns through any arbitrage opportunity due
to a mismatch in put-call parity that may exist in the market. The Fund
can also earn income through premiums by writing call options that are
worthless at time of maturity. Options are useful to hedge risk if the
Fund should want to protect its investment, for example by investing in
call options to hedge risk against bearish market trends.

5. Information on market ‘Events’ that can affect the short term and long
term outlook
An event can significantly affect the volatility of stock price and its value.
Market events such as regulations announced by the Govt. or change in
treasury rates ( esp. in case of banks) or company events such as new
product launches, annual/quarterly earnings report or sector -specific
regulation need to be studied. Past financial performance might be soft
indicator of future performance but any analysis on predicted maturity
price should take events into account. For example, higher dividend in
one quarter might affect the stock price bullishly but also result in
increased volatility of asset value. Events can be categorized as market-
wide or stock-price events.

Name : Ashlesh Mangrulkar SID: B18014 Section A

 Analysis and Interpretations

1. Analysis of JPMorgan Chase & Co. and Facebook Inc.

a) JPMorgan Chase & Co.
Since 2009, JP has shown stable operating and net incomes. It has paid
regular dividends to its shareholders. In 2014, it is projected to pay an
annual dividend of $1.52 per share, in line with existing trends. The stock
price hasn’t shown significant variability and returns per day is between
-$0.04 to $0.04. The Price to Earnings ratio had shown a decrease in 2012
but has bounced back since then. The financial firm has strong
fundamentals and is not highly volatile. The stock has performed well in
2013 ( lowest stock price ~ highest stock price in 2012) and investors will
prefer to go bullish on this stock.
b) Facebook, Inc
Facebook went public with its IPO in 2012. It hasn’t paid any dividends to its
shareholders and is not projected to pay any in the foreseeable future. The
stock is subject to high volatility, by analyzing the daily stock price returns.
One particular instance had a return of 29.61% return. The business model
of Facebook is fairly robust and is globally poised to be the next big thing,
but since it’s a fairly new company its stock price is subject to
misinformation and conjecture. Its P/E ratio should stabilize in a few years,
as should its net income and revenue, because it leads to significant
unpredictability for investors. Most investors would prefer to hold
Facebook’s stock and go long, with a call option to hedge their investment.

Options Strategy
The Fund has conventionally favored higher investment in dividend paying
firms. The same will be followed here. The aim is to increase risk adjusted
performance of the fund, and increase income through call writing to
support its cash dividend payout policy.

Name : Ashlesh Mangrulkar SID: B18014 Section A

 Facebook, Inc.
Covered Call : A covered call strategy is useful to generate steady income
from a stock that is already owned, while safeguarding the investment. It
also limits the amount of gains that can be made. Through covered calls we
sell a call option at a strike price above the current stock price. The
following situations may occur hence :
a) The stock price increases above the strike price : In that case the buyer
of the call will exercise his right to the option and purchase the stocks
from us. At maturity, our income will be limited by
Profit = Amount made by writing call + (Strike price of Call - purchase
price of stock)*no. of shares
b) The stock price remains neutral or falls below the current
traded price: The buyer of the call will not exercise his right to buy shares
and it will become worthless. Our income will be restricted to the
premium earned from selling the call. However, the capital has
depreciated in this case on our investment in the stock.
Profit = Premium made by writing call
Profit/Loss

Stock Price
Strike Price

Profit/Loss
Bull Buy Write
Spread Strike 1 Strike 2
Stock Price 60 65
50 -0.15
55 -0.15
57.74 -0.15
60 -0.15
62.5 2.35
65 4.85
68 4.85

Name : Ashlesh Mangrulkar SID: B18014 Section A

JPMorgan Chase & Co.
Bull Call Spread
In case of this stock, we expect a moderate increase in the price of the stock,
hence we will purchase a call option at a strike price and write the same
number of calls at a higher strike price. The following cases may occur:
a) The price of the stock falls below the 1st strike price : The maximum loss
is made and is equal to the price of premium paid for the 2 calls.
b) The price of stock is between the 2 strike prices : The total payoff is
equal to difference of the 2 calls and the profit made from selling the
stock at a higher value
c) The price of stock exceeds the 2nd strike price : The total payoff is
maximized at the 2nd strike price. Any movement above the 2nd strike
price is forfeited.

Strike Price 2
Profit/Loss

Strike Price 1 Stock Price

The profit/loss for this analysis is given below

Profit/Loss
Bull Buy Write
Spread Strike 1 Strike 2
Stock Price 60 65
50 -0.15
55 -0.15
57.74 -0.15
60 -0.15
62.5 2.35
65 4.85
68 4.85

Name : Ashlesh Mangrulkar SID: B18014 Section A

 Recommendations

The Fund is operating on some rigid criteria which have been set by its board of
directors. It seeks to supplement its income by trading in options.
The recommendations are :
1. The Fund doesn’t have significant expertise when it comes to options
trading, and hence for different stocks under its portfolio it will have to
devise a separate strategy for each stock based on its business
fundamentals. It will have to invest in developing the intellectual capital
to develop some level of expertise in this regard. In case of Facebook,
Inc. it is a volatile stock compared to JPMorgan Chase & Co. which was
offering dividends regularly to its shareholders.

2. To prevent return of capital, the Fund can effectively change its dividend
payout criteria, w.r.t market performance. Rather than forcible sticking
to a fixed payout plan, it can tie it with market performance, thus
rewarding shareholders when markets perform above expectations.

3. Since the stock price is trading below NAV, the Fund is inclined to take
bold steps to improve its performance, but such a knee-jerk reaction is
undesirable. It could try to improve its performance by changing its
investment model of 75%-25%. In case of IPOs though no dividend is
paid, the Fund can take advantage of the market movements in its favor.

4. The Fund can benchmark its performance with other closed end Mutual
Funds that are operating in the same market and compare the returns it
offers w.r.t to them. It can adopt their best practices.

Name : Ashlesh Mangrulkar SID: B18014 Section A