Market Beat: Covered calls for income
December 2, 2011
TRUCKEE, Calif. andamp;#8212; Investors who have a need for steady monthly income may find todayandamp;#8217;s low interest rate, volatile market a very challenging environment to get their needed cash flow. Interest rates are near zero. Dividend paying stocks can be quite volatile. Income oriented investors can find themselves in a situation where they keep having to take on more and more risk to produce the income they need.One possible solution, though it may not be suitable for all investors, is to sell call options against a broadly diversified portfolio. A call option is a contract that gives the owner of the contract the right to buy the underlying security at a certain price within a certain time frame. The party who sells the option receives immediate cash in their account in exchange for being willing to sell their security at a set price by a certain date. An income oriented investor can get immediate monthly income into their account by being willing to sell some holdings at a higher price.There have been a few major academic studies that confirm that a covered call strategy on an equity index will deliver superior risk adjusted returns. In 2007, Kapadia and Szado at the Isenberg School of Management at the University of Massachusetts did a study on writing calls on the Russell 2000 Index that concluded, andamp;#8221;The results demonstrate that the strategy has consistently outperformed the Russell 2000 Index on a risk adjusted basis.andamp;#8221;In 2006 Callan Associates did a similar evaluation of a covered call strategy on the Sandamp;P 500 Index and concluded that the covered call strategy delivered superior risk adjusted returns over an 18 year period from 1988 to 2006. The coursework for the Certified Financial Planner (CFP), designation teaches that covered call writing has been shown to be an effective tool for both income and risk reduction.Investors can potentially increase their income by selling covered calls on bond funds, broad based stock index funds, commodity funds or individual stocks. When used with bond funds or dividend paying stock funds the investor can expect to add the call premium received to the dividends that the fund will pay out.Remember, options are not suitable for all investors. Itandamp;#8217;s important to understand exactly how they work before implementing an options strategy in your portfolio.andamp;#8212; Kenneth Roberts, a Truckee-based Registered Investment Advisor, has been in the securities business since 1992, has worked as a branch manager for a major Wall Street firm and is currently a portfolio manager for Fusion Asset Management. Information on his money management service can be found at http://www.fusiontargetretirement.com or by calling 775-675-8065. Past performance does not guarantee future results. Consult-your financial adviser before-purchasing any security.