By Peter Mastrantuono
Most investors do not utilize options as a part of their overall investment approach, even though different option strategies can be employed to protect portfolios, leverage profit opportunities and create income. One such strategy, covered call writing, can be used in IRA and nonretirement accounts to boost income in a low-yield world.
Before diving into covered call writing, it may be helpful to review some basics about options. Options are a contract that gives the buyer the right to purchase (call option) or sell (put option) the underlying security at a certain price by a certain date. The seller of options is obligated to sell (call options) or buy (put options) the underlying security, if the option is exercised.
Typically, an option contract is for 100 shares of a publicly traded stock, though options exist on a wide range of financial instruments, such as indexes, currencies and commodities.
When writing covered calls, the term “writing” means “selling” in Wall Street parlance. An investor who sells, or writes, a call option receives money equal to the call premium (the market price of that option). In exchange, the investor is obligated to deliver the underlying shares at a prescribed price by a certain date if he or she is “called.”
When a call option is “covered,” it means the investor already owns the shares that he or she may be obligated to deliver in the future.
An example may be helpful. John Smith owns 100 shares of XYZ Corp. He decides to write a covered call, agreeing to sell his shares at $60 per share (the “strike price”) within the next three months. (The stock currently sells for $57 per share.) John receives $200 ($2.00 x 100 shares) in premium income for writing the call.
Should XYZ Corp. remain under $60 throughout this three month period, no investor will buy those shares from John since they can be bought more cheaply on the open market. However, if the price rises above $60, John may have his XYZ Corp. shares called.
If XYZ Corp. remains under $60, the option expires worthless and John gets to keep the $200 of premium income and his position in the stock. If the stock is called, he must sell his shares at $60 per share, but gets to keep the premium income. If the stock trades over $62 ($60, plus $2 per share premium income), he would have been better off not writing the covered call. (This example does not include commission costs.)
Flat or declining markets are typically the best environment for writing covered calls since the risk of having a stock called is lower.
For retirees, covered call writing can be used as an income generation strategy to squeeze out additional income from existing stock holdings, or by investing in companies with attractive dividend payouts and writing calls against those positions to supplement the dividend income stream. As each option period ends, the investor would write new call options to generate ongoing premium income.
Investors should be prepared to relinquish ownership in the stock and accept that upside potential may be capped by the call’s obligation to sell at a pre-determined strike price.
When implementing a covered call option writing strategy, it may be highly beneficial to work with a financial advisor who can help with understanding the risk-reward trade-offs associated with available option contracts.
Peter Mastrantuono is a contributing writer to www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.