Calling on Covered Calls for More Income

Interest rates are rising, but are likely to remain low in absolute terms for some time. Throw in persistent inflation, and the climate is rough for clients needing more income.

It’s trying for advisors, too. The fixed income assets that aren’t extremely rate sensitive usually offer low yields. Alternative and fixed income assets with high yields are often vulnerable to rising interest rates. In other words, it’s hard out there when it comes to finding income.

Fortunately, there are some solutions – some of which are likely going overlooked by advisors and clients alike. One idea is covered calls and the related funds, which can be deployed in retirement accounts, too.

Owing to the high levels of income associated with covered calls, even clients who are options novices are likely to have some interest in this strategy. However, due to the mechanics involved with putting these trades on, advisors play an important role in terms of education and guidance.

Covered Calls: Timing Is Crucial

As advisors know, timing matters with covered calls, meaning this strategy is best deployed during lethargic market settings.

“Covered calls perform best when markets are rangebound. The way it works is that a fund writes (sells) call options on a specific index, either the S&P 500, Nasdaq 100, or Russell 2000,” according to Global X research. “The income from selling the options is paid out to investors in the form of yield. Investors have full exposure to the downside, as the calls expire worthless in a down market. And they have capped exposure on the upside, as the underlying can be called away. When volatility rises, the premium received rises to compensate for the higher volatility in the market.”

Sluggish markets are ideal for covered calls because it allows the options seller to collect income (premiums) with lower risk of being called away. On that note, advisors should tell clients that covered calls aren’t perfect. This strategy can lag on strong-trending bull markets.

“Ia reasonably tight range, covered calls benefit from receiving the premium income and a potentially small improvement in the underlying equities, while not having the underlying called,” adds Global X. “In a rising market, covered calls typically underperform the overall market due to the underlying being called away, which affects the capital gain return, not the income return. In a declining market, covered calls provide a small buffer of protection due to their premium income.”

Adding Protection to the Mix

Another idea for advisors to consider is the options collar, which mixes in elements of options selling and downside protection.

“For investors looking for downside protection in a declining market, a collar strategy can be appropriate. Like a covered call strategy, calls are sold on an index like the S&P 500 or Nasdaq, but with a collar, puts are also purchased on the index,” concludes Global X. “The risk/reward tradeoff is a lower yield relative to the covered call on its own. However, the downside protection might be more prudent, depending on short-term views about the current environment.”

Even with the downside protection offered by collars, the income level is likely to be higher and less rate-sensitive than what clients are currently finding with high-quality bonds.

Related: Where to Turn in Search for Profitable Growth