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27 August 2021 by National Bank
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Covered call strategies help to enhance cash flow for investors looking for income solutions.
The search for yield has become increasingly difficult with yields remaining very low relative to historical norms. Aging clients, and pre-retirees require higher yield and sustainable monthly income.

Enhancing Yield and Reducing Risk with Covered Calls

In recent years there has been a growing demand for covered call solutions within managed products and for good reason as these products offer a number of benefits;

Covered call solutions benefits

How do the strategies work?

Covered call strategies work by holding a stock and selling (“writing”) a call option on the underlying stock. Selling a call option gives the buyer the ability to purchase the stock at a later date at an agreed upon price (the “strike price”). By selling the option the portfolio receives a premium, providing additional cash flow.

How do the strategies perform in different markets?

Down Markets

  • The decline of the underlying stocks is partially offset by the call premium received
  • Generally covered calls will outperform their underlying portfolios

Rising Markets

  • When stock prices rise significantly and exceed the strike price, the call option will move into the money
  • This caps the gain for the call writer based on the strike price and premium received
  • Typically in rapidly rising markets, covered calls will underperform their underlying portfolios

Sideways Markets

  • As markets become highly volatile, covered call strategies may underperform as the strike prices is written closer to the money and is reached more frequently
  • The covered call strategy may outperform if the strike prices are further out of the money
  • During volatile markets, covered calls performed similarly, but exhibited lower volatility
Payoff Characteristics of Owning 100 Shares and Selling 1 ATM Call Option

Key Terminology

Out-of-the-money: A call option is said to be the out-of-money when the price of the underlying stock is lower than the strike price. If this difference is substantial, the option is deeply out-of-the-money.

At-the-money: A call option is said to be the at-the-money when the price of the underlying stock is identical or rela- tively close to the option strike price.

In-the-money: A call option is said to be the in-the-money when the price of the underlying stock is higher than the strike price. If this difference is substantial, the option is deeply in-the-money.

Considerations when selecting covered call solutions

Get Comfortable With The Portfolio

Be comfortable with the underlying portfolio as an invest- ment, and review the dividend yield, which may provide a strong starting cash-flow. Consider the volatility of the underlying stocks, while higher volatility may lead to higher premiums, they may be subject to greater down- side moves.

Option Selection

Out of the Money (OTM) options allow for some market movement.

Percentage Written

Consider how much of the portfolio is overwritten. By not writing on the entire portfolio, more upside is available.

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