Market Beat: Covered calls for income
Income oriented investors can have a difficult time finding good yields in this low interest rate environment. Interest rates could rise again in the future, but for the time being it looks like we’re in a disinflationary environment due to several factors.
One thing to be careful of is known as chasing yield. In order to get better coupon rates on bonds, some people will purchase bonds with lower credit ratings to get higher yields and consequently having more default risk by buying the high yield or junk bonds. Default rates for junk bonds can be about 40% in times of recession.
One strategy that can be used to produce some extra income is known as covered call writing. Covered calls are put together by selling call options on a stock or exchange traded fund that you already own. Options are not suitable for all investors and investors should thoroughly understand how they work before using them.
If you sell a call option against a stock or ETF that you own, you are giving someone the right to buy it from you at a set price by a certain date. The price is known as the strike price and the date is called the expiration date. There is a disadvantage and an advantage to every option strategy and the disadvantage to covered call writing is that you are limiting your upside potential for the stock or ETF. The advantage is that you get to collect the option premium as income.
The way the strategy works is pretty simple, say you own XYZ stock at $25 per share and are willing to sell it for $30. You could sell a $30 call option on XYZ and collect $1 in option premium. If XYZ rises above $30, you’ll sell if for $30, but you get to keep the $1 premium, so your net price is $31. If it stays under $30 by the time the option expires you get to keep the $1 as income.
If you repeat the process the income from the options selling can end up being substantial. There have been numerous academic studies on option writing that conclude that selling covered calls can enhance returns and lower risk. If you sell covered calls on a dividend paying stock or ETF, you can collect the dividends and the call premium as income. Bond ETFs can be used as well with good results.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://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.
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