As a financial advisor, I am always looking for ways to generate more income for my clients’ portfolios. Bonds can be great income producing products and are usually quite stable. The downside of bonds is that they don’t give investors any upside appreciation. One investment strategy that can give you both growth and income is called a covered call strategy. Trading options may sound intimidating, but they can be used to cut risk and to generate income in your portfolio.
What is a Covered Call?
A covered call is an options strategy where an investor owns an asset, typically shares of a stock, and sells a call option on that same asset. The call option gives the buyer the right to purchase the underlying asset at a predetermined price within a specified period. In return for selling this call option, the investor receives a premium, which they keep regardless of what happens with the option.
How Does it Work?
Let’s break down the covered call strategy with an example:
Apple stock is trading at $170. You can sell an option to sell your Apple stock on July 19 for $175. One option contract is 100 shares of stock. You would receive $6.50 in premium from selling your option. That gives you a 3.8% yield for 3 months.
| Price | Dollars | |
|---|---|---|
| Buy 100 Shares of Apple | 170 | 17,000 |
| Sell 1 Contract- 175 Call | 6.50 | 650 |
| 3 Month Covered Call Yield | 3.8% |
Possible Outcomes
If the price of Apple stock goes lower, your first 3.8% in losses is covered by the premium that you received from selling the option.
If the price stays around $170, you will receive your 3.8% yield.
If the stock rises to $175 or above, you may have to sell your shares at $175, even if the stock appreciates well above that $175 price. Your total return would then be:
$5 appreciation on the stock (175-170) plus the $6.50 in option premium = $11.50.
That makes your 3 month return 6.8%.
| Apple Stock Price at Expiration | Percentage Move | Gain or Loss $ | Gain or Loss % |
|---|---|---|---|
| 150 | -11.8% | -13.5 | -7.9 |
| 160 | -5.9% | -3.5 | -2.1 |
| 170 | 0.0% | +6.5 | +3.8 |
| 175 | +2.9% | +11.5 | +6.8 |
| 185 | +8.8% | 11.5 | +6.8 |
What Happens after your Option Expires?
What happens after July 19 depends on where your Apple stock is trading as that date arrives. If the stock remains below $175, you can choose to sell another option at a later date and continue to make this an income generator for your portfolio. If the stock is trading above $175, you may have the option of buying back that option and rolling it to a further out date and/or price or you could simply sell your shares for $175 for a solid return.
Tax Considerations
Options are subject to the same holding period rules as other investments. If options are held for more than a year, they are taxed at the long-term capital gains rate, 15%, or 20% for higher earners. If options are held for less than a year, they are taxed as ordinary income. There are some covered call funds that use Index Based Options that offer more advantageous tax rates. They are typically taxed as 60% long-term and 40% short-term. Covered calls are probably best used in retirement accounts due to their taxation, but also work just fine in taxable accounts.
The Downside of Covered Calls
Like with any other investment, there are risks and consequences to consider:
- Limited Upside: By selling a call option, you cap your potential upside if the stock price rises significantly above the strike price.
- Limited Downside Protection: In our example, you received a 3.8% yield. If your stock depreciates by more than 3.8%, you will lose money.
How Can I Use Covered Calls?
This strategy can be used on individual stocks, indexes like the S&P 500, or Exchange Traded Funds (ETFs). ETFs give you diversification of the underlying asset and, typically, monthly income. Using individual stocks gives you less diversification but it can give you more options as to how far out in time and price you want to write your option. This can be very effective for highly appreciated stock that you don’t want to sell for tax purposes, but would like to use to generate more income for your portfolio.
Writing covered calls is not meant to be a replacement for the equity portion of your portfolio, but it can be a great way to increase your income. The income portion of your portfolio should have a diverse mix of income producing investments, especially as you move into retirement.
If you think that covered call strategies could fit into your portfolio or have any questions, please reach out to me at shawn@smrstrategic.com.
