Covered Calls: An Equity Solution for Enhanced Income


In an era of low yields, elevated inflation, and choppy equity markets, some investors are turning to non-traditional methods to generate income and mitigate volatility. Covered call option writing, also known as a “buy-write” strategy, can offer a steady stream of incremental income while reducing downside risk for a portfolio.

In this white paper:

  • Understanding the basics
  • What is a covered call strategy?
  • How it works (with examples)
  • Benefits and risks
  • Covered call strategies in varying markets
  • How to invest in a covered call strategy
  • Single stock vs. Index options
  • Understanding yield from a covered call strategy
  • And more…

COVERED CALLS: UNDERSTANDING THE BASICS

Before diving into the benefits of this type of investment strategy, it is important to first understand the mechanics of stock options. A call option is a contract by which the buyer owns the right to purchase a security at a predetermined price on or before a specified date. This is known as the strike price. The seller of the call option has an obligation to sell the underlying security to the contract owner at the stated strike price.

Another type of contract is a “put option.” Unlike call options, put options give the buyer the right to sell an underlying security at a predetermined price on or before a specified date.

Investors engage in the buying and selling of call and put options contracts for a number of reasons, such as if they believe a security’s price will rise or fall and wish to benefit from anticipated price movement, to generate income, or to hedge the risk of a portfolio or position. In the case of call options, the seller (or writer) of the call option receives a premium for offering the contract. If the underlying stock rises to or above the strike price, the writer would be obligated to sell the stock at the specified price if the buyer exercises the option or allows for automatic exercise—enabling the buyer to potentially get the stock at a discount, hence the benefit to the buyer. The writer in this instance has forgone the upside beyond the strike price in exchange for the premium generated by the sale of the option.

Options can be written on a wide array of assets, including stocks, exchange-traded funds (ETFs), currencies, and commodities. For covered call strategies, stock and ETF options are most common.

WHAT IS A COVERED CALL STRATEGY?

A covered call strategy owns underlying assets, such as shares of a publicly-traded company, while selling (or writing) call options on the same assets. Selling call options produces a stream of cash flow for the portfolio. This income can act as a source of yield for the investor or be reinvested to help offset losses in a market decline. Adding to the appeal for income-seeking investors is the possibility of dividends and potential capital gains generated from portfolio activity, distributed regularly.

From a risk and return perspective, covered call strategies tend to perform in line with the S&P 500® during periods of steadily up, declining, or flat markets, and lag when the market rises rapidly. All with less volatility, as measured by standard deviation. Over long periods of time and spanning all types of markets, covered call strategies offer a balance of market participation, risk mitigation, and income generation.

HOW IT WORKS:

Consider a portfolio that consists of 100 shares of XYZ stock at a current price of $70. Call options with a strike price “out-of-the-money” at $75 have a premium valued at $3.00 per share. The portfolio manager implements the covered call strategy on 100 shares and receives $300 of income in premium.

If the stock price remains at $70 when the option expires, the portfolio’s value would be $7,300 and the option would not be exercised.

If the stock price drops, the loss of value is lessened because it received a premium for the call option.

If the stock price drops to $67/share when the option expires, the new portfolio value would be back to $7,000. (100x$67=$6,700 +$300=$7,000). This is the break-even point.

If the stock price rises, the contract may be exercised, and the portfolio would have to sell the security for less than its current market value while retaining the premium received from selling the call option.

Let’s say the stock rises to $80/share, the option is exercised, and the writer is obligated to sell the 100 shares at $75/share. With the premium, the portfolio’s new value would be $7,800. (100x$75=$7,500+$300=$7,800) versus the $8,000 value of the stock. The portfolio would then be able to invest in the same or a different security to begin the process all over again.

BENEFITS OF A COVERED CALL STRATEGY

Covered call strategies offer benefits of diversification, growth participation, dampening downside risk, and supplemental income.

Diversification – Adding a covered call strategy to a portfolio can provide added diversification for most investors.

Growth participation – Selling “out-of-the-money” call options allows the portfolio to benefit from rising stock prices if they occur.

Dampen downside risk – Income generated from call premiums received can help offset price depreciation.

Supplemental income – In addition to dividends and capital gains (if any), call premiums can provide an income stream.

RISKS OF A COVERED CALL STRATEGY

The two most prevalent risks associated with covered call strategies is market risk and opportunity risk.

Market risk – As with any strategy involving stock ownership, price decline risk is real. Some managers may try to mitigate this risk by purchasing put options.

Opportunity risk – If the stock price appreciates beyond the strike price, the covered call writer is obligated to sell the security and no longer participate in the rising price. While the manager may purchase additional call options to help limit this opportunity risk, the upside will likely always be lower when the stock price appreciates rapidly.

To continue reading about covered call strategies, download the full white paper PDF.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”), which also includes the Madison Scottsdale office. MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

S&P 500® is an unmanaged index of large companies and is widely regarded as a standard for measuring large-cap and mid-cap U.S. stock-market performance. Results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.

The writer of a covered call option forgoes, during the option’s life, the opportunity to profit from increases in the market value of the security covering the call option above the sum of the premium and the strike price of the call, but has retained the risk of loss should the price of the underlying security decline.

Equity risk is the risk that securities held by the fund will fluctuate in value due to general market or economic conditions, perceptions regarding the industries in which the issuers of securities participate, and the particular circumstances and performance of the companies. In addition, while broad market measures of common stocks have historically generated higher average returns than fixed income securities, common stocks have also experienced significantly more volatility in those returns.

The preceding examples are based on American-style options. Other variations exist.

Diversification does not assure a profit or protect against loss in a declining market.

Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in the report constitute the authors’ judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

For more information on options and related risks, contact your financial advisor and review the Options Clearing Corporation “Characteristics and Risks of Standardized Options” available at www.theocc.com.

Definitions
Option: The right to buy or sell a specified amount or value of a particular underlying interest (or security) at a fixed exercise price by exercising the option on or before its specified expiration date.

Call option: An option that gives the right to buy an underlying security.

Put option: An option that gives the right to sell an underlying security.

Strike price: Price at which the option holder has the right to purchase or sell the underlying security.

Premium: The price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option. It is the price set by the holder and writer, or their brokers or the overall market, in a transaction in an options market where the option is traded. It is not a standardized term of the option and does not constitute a “down payment.”

Exercise: The holder of an option wishes to buy (in the case of a call) or sell (in the case of a put) the underlying security at the exercise price.

Expiration date: The date on which the option expires. If an option has not been exercised before its expiration, it ceases to exist — that is, the option holder no longer has any rights, and the option no longer has any value. An American option may be exercised at any time before the expiration date, while a European option may only be exercised on the expiration date.

Long and Short: The word Long refers to a person’s position as the holder of an option, and the word Short refers to a person’s position as the writer of an option.

At the money: The current market value of the underlying security is the same as the exercise price of the option.

In the money: The current market value of the underlying security is above (call options) or below (put options) the exercise price of the option.

Out of the money: The current market value of the underlying security is below (call options) or above (put options) the exercise price of the option.