Exploring Covered Calls for Income

This year's stock market is behaving differently from 2017, and investors may want to change some of their strategies. Although the Federal Reserve is slowing raising interest rates, they still remain historically low.

Investors may want to look at other ways to get income besides low-yielding Treasurys, risky junk bonds or dividend-paying stocks. One idea to consider is to use covered calls in the options market against individual stocks, or investors can try mutual or exchange-traded funds that make covered calls part of the portfolio strategy.

[See: 7 Under-the-Radar Financials to Buy for Income.]

Making the call. In the stock options market, a call is the right, but not the obligation, to buy or sell a stock at a specific price (known as the strike price) during a specified time frame.

A covered call strategy works best when investors believe that the stock they're holding won't see sharply higher or lower prices. An investor who holds a stock can sell (also known as write) a call option above the stock's current price to receive a premium payment, generating income.

In this way, a covered call trade acts like insurance, says Brett Manning, senior market analyst at Briefing.com in Chicago. "Essentially what you're doing when you're writing anything is you're insuring against the upside in the market and you're owning the asset underneath it," he says.

That premium payment is what generates income, giving investors a bit more return on individual stocks whose prices might not move much. And if prices fall slightly, the owner of the stock loses less money because the premium payment offsets some of the drop in stock price.

The downside of a covered call is that investors cap how much they can make if prices rally, since the person on the other side of the trade has the right (but not the obligation) to buy the stock from the investor if the value rises to the strike price.

While covered calls weren't a good strategy last year, they can work in flat markets or ones that might fall a little. "It's like going to cash in a lot of ways, except it can generate income if the market doesn't go up," Manning says. "So it's an explicit bet that it would be a good time to not be exposed to [a rising stock market]."

[See: 8 Ways to Buffer Your Portfolio From a Market Slide.]

Some caveats and a strategy to try. Income investors who want to try covered call strategies should keep a few factors in mind. Look for blue chip, large-cap stocks that pay dividends between 2 to 6 percent and trade more than a million shares per day. "Those are the types of stocks that have very active options," says John Person, president of NationalFutures.com and an options expert in North Palm Beach, Florida.

Avoid using covered call strategies two weeks before the company's quarterly earnings, when there's a greater risk of the stock moving sharply, he says. Select a strike price that's about 2 to 5 percent above the stock's current price, known as an out-of-the-money call, and pick a time frame so that the option will expire in 30 days or less. That allows investors to still collect a premium while reducing the chance of the stock moving based on the news or other events.

By using a covered call strategy with a dividend-paying stock, the investor collects both the dividend and the premium for a little extra income, he says. Person says investors should only use a covered call strategy on half of all their stock holdings because if prices for the underlying asset rise higher than the strike price, the buyer of the option, who took the opposite side of the trade, has the right to "call in" or buy that stock at the higher price.

Selling covered call options gives the sellers "an extra bonus of collecting revenue while allowing them to keep a portion of their long-term stock position," he says. "And if the stock does have an exceptional upside surprise move, they're only called out a part of their stock and they make a profit [on the stock sale]."

Fund versions. Covered calls for individual securities require some baby-sitting of trades. "Many advisors don't like to do this with clients because it involves a lot of monitoring of positions and knowing when the options expire," says Christian Magoon, chief executive officer of Amplify ETFs in suburban Chicago. Amplify ETFs runs the Amplify YieldShares CWP Dividend & Option Income exchange-traded fund (ticker: DIVO).

For people who don't want to monitor positions that closely but are interested in the extra income from these strategies, closed-end funds and ETFs are the way to go. Along with Amplify's ETF, examples include Eaton Vance Enhanced Equity Income (EOI), a closed-end fund with a 7.3 percent yield that currently trades at a 4.2 percent discount to its net asset value, or Powershares S&P 500 BuyWrite Portfolio ETF ( PBP), which has a yield of 10.94 percent. Horizons Nasdaq 100 Covered Call ETF ( QYLD) has an 8.1 percent yield.

Some of these funds, like EOI and DIVO, are actively managed funds that employ these strategies against individual shares in the fund, while PBP and QYLD are index-based products. The active funds are likely to be more volatile than the index product. That volatility could potentially mean more income, while the index products could produce a higher equity return.

[See: 10 Stocks Already in a Bear Market.]

Whether they use individual stocks or funds, investors, Magoon says, should think about what they want from covered call strategies: income or equity exposure. "If it is as an income sleeve where I'm really trying to get additional income, then I may not mind having the stock called [in] more frequently," he says. "But if you want more equity exposure, the index-based products are less likely to be called."

Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.