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27 August 2021
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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;
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
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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