Covered call writing can provide lower risk, additional income

Kevin B. Murray, BridgeTower Media Newswires

Writing (selling) covered calls is a conservative strategy that can enhance the income from one’s portfolio, while reducing the portfolio’s overall risk. Option strategies are often viewed as being very “risky,” while writing covered calls is an option strategy that takes the conservative side of the trade while the option’s buyer is taking the risky side of the trade.

There are both open-end and closed-end funds that engage in writing (selling) covered calls. A conservative investor can purchase these funds and gain the advantages (lower portfolio risk and additional income) that a covered call strategy can provide.

As an owner of an individual stock (or of an Index such as the S&P 500), you have the right to sell the stock at any time at the market price. What is less well known is you also can sell this right to someone else in exchange for a premium. Selling a covered call is a contract you enter into with the buyer who receives the right to purchase the shares from you at an agreed upon value (strike price) for a cash payment (premium) during a specified period of time.

As an example let’s say you own 100 shares of XYZ, which has a current market price of $40 per share for a total value of $4,000. Furthermore let us say you can sell someone the right to buy XYZ from you at $44 (strike price) over the next three months for a premium paid to you of $2 per share.

The advantage to you is the receipt of the $2 premium. The disadvantage to you is if the market price of XYZ goes above $46 (the $44 strike price + the $2 premium paid to you) you will not participate in any gain above the $46.

If the market price of XYZ stays below $44 a share over the three months you pocket the $2 premium and the option you sold expires without the option buyer purchasing your XYZ. The buyer would have to pay you $44 per share and would not do so if he/she could buy XYZ at a market price below $44 a share. Once the option expires you can write a new option on XYZ and receive another premium.

If the price of XYZ fell, stayed steady or increased to a value $46 per share ($46 would give you a 15% profit for three months), you would be better off than if you had just held XYZ and not written the call. If however the price of XYZ went to $50 a share (a 25% increase in three months), you would only receive the $44 strike price and the $2 premium. Thus while you would make $6 per share (a 15% profit) you would not get the entire gain of $10 per share. The extra $4 per share gain would go to the buyer of the option who would make a 200% profit on his/her $2 investment (the premium they paid for the option). The buyer of the option takes a 100% loss of the $2 premium paid to the seller if the price of XYZ does not go above the $44 strike price.

For those conservative investors who wish to lower their downside risk, and enhance the income they receive, selling covered calls may make a lot of sense. Pursuing this strategy via a fund is a simple matter. Closed-end funds that sell covered calls can provide an additional source for performance in that they can be purchased at discounts to current net asset value. If held until the discounts narrow, closed-end funds can add to the performance and lower the risk of a portfolio that follows a covered call strategy.

As with all investment strategies, selling covered calls works well in many types of markets (flat market/declining market/slightly positive market), but not so well in others (a strong bull market). Using the strategy with part of your portfolio adds one more arrow to your investment quiver. As with having securities of different market capitalization and from different market sectors, using several different strategies adds diversification to your portfolio. As we all know, diversification reduces risk.

Protecting your assets from risk is critical to the success in the long run for every investor. Using many different types of investments can lower your risk. A cliché is that you can win by not losing. This means that avoiding or lessening major drops in your portfolio helps long-term performance. Using several different strategies, including selling covered calls, can both reduce your risk and increase the income of your portfolio.


Kevin B. Murray, is a vice president at Karpus Investment Management, an independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534 (585-586-4680).