Retirees who need income today may find it very challenging to produce their desired cash flow. Interest rates are well below historical norms. As a result, many retirees are stretching for yield and buying high-yield bonds and bond funds and dividend paying stocks.
The risk-reward ratio in the high-yield bond market isn’t too good right now, and investors may not be getting compensated for the risks they are taking. Dividend-paying stocks can also be a good income alternative depending on your individual risk tolerance.
A steady income stream can be obtained by selling covered calls against dividend-paying stocks or funds. Remember, options are not suitable for all investors.
The main drawback to selling covered calls is that you are limiting the upside potential of your stock by giving someone else the right to call it from you at the strike price on or before the expiration date. However, if cash flow is your primary objective, covered call writing might be a strategy worth considering.
Volatility is an important concept for investors to understand. Two different stocks may have very similar returns, but have completely different volatility characteristics. High portfolio volatility can make retirees nervous.
Two different types of volatility that covered call writers need to understand are historical volatility and implied volatility. The historical or statistical volatility is a measure of how volatile the stock has been, and it can be measured over different time frames.
The implied volatility is derived from the price of the option contract and will vary with different strike prices and expiration dates. High implied volatility indicates that the market is anticipating large price movement in the stock.
There are many large cap stocks that have dividend yields in the 3 percent area; when combined with call writing it is very realistic to get static annualized returns of 4 percent or so from the call income, which adds up to a static return of about 7 percent. You’ll also be allowing the stock some room to move up in price, but will be limiting the potential price appreciation to about 10 percent annually.
Covered calls don’t have to be written on individual stocks; they can also be written on ETFs if you have a need for diversification. They can be written on broad based index funds, sector funds and bond funds. Stick with the large cap issues which are the most liquid, so you get the best executions.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.