Income-generating assets – dividend stocks, commercial real estate or even corporate bonds – hold a special place in a high-net-worth investor's portfolio when the stock market is volatile and range-bound, like it appears to be today.
For this reason, "covered-call writing" has been a particularly appealing and effective portfolio strategy during the past year.
A covered call is a call option sold for a premium on a stock held in your portfolio. A call gives the buyer of the option the right to buy that stock from your portfolio at a specified price, known as the strike price, over a specified period of time.
If the stock appreciates beyond the strike price, the buyer of the call can exercise the option to purchase the stock at the strike price. An investor who uses a covered-call strategy will limit some of the upside potential of the stock in exchange for the call premium (cash flow) earned on those stocks.
Covered calls provide a partial hedge against a decline in the price of your stocks. If the stock price declines, it will have to decline more than the value of the premium received for the investor to be in a total loss position. Clearly, during a period of declining or flat stock prices, a covered-call strategy will outperform strategies that simply buy and hold stocks.
During historical moderate bull, range-bound and bear markets, a covered-call strategy tends to outperform its underlying stocks. During a period of rapidly rising stock prices, a covered-call strategy would still deliver a positive return, but it would typically lag behind the return of a traditional buy-and-hold stock strategy because any gains beyond the strike price are capped.
Statistics bear this out. From October 31, 2009, to October 31, 2011, the CBOE S&P 500 2% Out of the Money BuyWrite Index (an index based on covered calls written on the broad-based S&P 500 stock market index) delivered a 23.11% return versus a 20.18% return for the S&P 500. From October 31, 2010, to October 31, 2011, a period of exceptional volatility, the index had a standard deviation nearly 20% lower than the S&P 500.
The advent of covered-call exchange traded funds (ETF), which offer pre-packaged covered-call strategies within an ETF, has created a simple way for investors to access professional covered-call strategies that were traditionally the domain of institutional investors.
These ETFs hold a passive portfolio of stocks that give them the appropriate stock-sector exposure and then run managed options strategies on those portfolios.
There are around a dozen covered-call ETFs in Canada, meaning you don't have to be an options expert to take advantage of the strategy. Given today's volatility, this strategy can make a lot of sense for all investors to reduce risk and improve one's tax efficient cash flows from investing. •
