Income Genius is a monthly newsletter from Iron Gate Global Advisors that reviews methods for intelligently generating income from your investments.
In this month’s Income Genius we discuss why volatility can be a good thing from an income perspective when you effectively utilize covered calls.
There are two great things about stock market volatility including the volatility we are experiencing now.
- You can buy great businesses (stocks) that are on sale. Those stocks that you have wanted to own for a long time but haven’t.
- You can sell options to create an extra income stream and to protect assets among other things.
Today I’m going to focus on number two – options . . .
We implement many different strategies for our clients. Strategies for protection, income, or taking advantage of a falling market are a few reasons we use options. In today’s Income Genius I want to focus on one basic strategy, covered calls.
According to Investopedia, a covered call is:
An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.
A covered call strategy can be implemented for the following reasons:
- Increase income
- Enhance long term returns
- Reduce portfolio volatility
The below image shows the value of covered calls. It is the CBOE Covered Call Index (BXY) from 2007 to present. You can not only see how the covered call strategy enhances returns but you can also see how it reduces portfolio volatility. In 2008 – 2009 the Covered Call Index fell less than the overall market.
Now don’t get me wrong, there is a risk to selling covered calls. The risks are:
- Limit your upside if the stock or market rallies considerably.
- You can still lose money on your stock if it falls.
For example, let’s take a look at one of the most bullish markets we’ve seen in recent memory, 2013 to 2015. You can see in the chart below that the S&P 500 index outperformed the Covered Call index.
The bottom line is, you need to learn when to use the strategy and when not too. Here are a few instances when an investor should utilize this strategy:
- Your individual goals call for more income than growth.
- When the market or individual stock begins to show some weakness and you want additional income.
- When the market is flat, up a little or sideways and you want additional income and a reduction of portfolio volatility.
An example looking at an individual stock. Let’s say you own XYZ stock. It’s currently trading at $50. For each of the past five months you sell a covered call on the stock.
|Month||Stock Price at Expiration||Strike Sold||Income Received|
In this example the stock fluctuates between $47 and $53. The amount of income you bring in is $3.30 per share for a reward of 6% (not including commissions).
The risk would occur if the stock went above your strike and you lose your stock. In June, for example, if the stock rose in value to $52 you would lose your stock and the potential upside. The other risk would be if your stock fell in value beyond the premium received.
For many of our clients covered calls is a core strategy, especially during volatile times. The benefits for them outweigh the risks.
Disclosure: Past performance is not a guarantee of future results. Options are not suitable for every investor as they carry risk that can be more than the initial investment. Please consult a financial professional before using options.