Covered Calls Could Provide a Fixed Income Boost

At their core, options of any kind include the right but not the obligation to buy or sell something at a certain price. And when investors think of options, their minds tend to go right to sophisticated traders, with multi-screen monitors, using words like “Condors” and “Iron Butterflies" to describe their strategies. But the truth is, basic options are pretty simple to understand and use in a portfolio. The reality is that options – like all derivatives – started out as insurance for a portfolio. It’s here that regular investors can use options to potentially generate more income and add fixed income-like stability to a portfolio.

Covered calls or a buy-write is one of the simplest options strategies to use. Here, an investor buys a stock or a basket of stocks tied to an index and writes call options that cover the position. A call option gives its holder the right to buy a stock from the option seller at a certain price by a certain date.

The option writer collects a fee for agreeing to the transaction, which becomes theirs no matter what. At the same time, they can keep the stock and collect the dividends it generates. However, if shares of the stock or ETF go past the strike price of the option, the option buyer will get to buy the shares. However, if it never gets to that point, the option expires worthless and the option writer gets to keep the shares.

So, why do this in the first place? The answer has to do with creating some fixed income-like stability on a side of the portfolio that has traditionally been more volatile.

For starters, using covered calls creates more income from a stock portfolio. Because of the option premium that sellers get, in addition to the dividends generating from the stock, using the strategy can effectively double or triple the yield a stock produces. In the current environment, this puts many yields from stocks and equity indexes above fixed income yields.

Additionally, using a buy-write and covered call strategies reduces volatility and lowers risk. Because of the strike price, upside is capped. But the option premium that writers collect can help limit losses. This tight band of returns tends to be stable, much like a fixed income portfolio. Overall, the long-term volatility of the major benchmark – the CBOE S&P 500 Buy Write Index – is about 30% lower than the S&P 500 alone. Moreover, the long-term returns for the index are solid. And, in fact, from the 1980s through the Great Recession, the buy-write index managed to outperform the bread & butter S&P 500. It was only in the recent zero interest rate environment that the relationship switched.

By using a covered call strategy, fixed income investors can still stay invested in the stock market and produce returns similar to their bond investments. With that, some analysts have suggest that covered calls be a main piece of a 60/40 fund and cover most of the stock sleeve.

Now, covered calls aren’t risk free and can only do so much to protect losses. But with markets such as the one we currently are in – one with no definitive direction – covered calls can be a fruitful tool to generate some very fixed income-like returns from the equity side of a portfolio. You certainly could write the covered calls yourself. If you own at least 100 shares of a stock or ETF, any good broker will let you do so.

However, buying a fund may be a better choice. And there are plenty of ways to do so, either via a mutual fund, ETF or closed-end fund. For example, the JPMorgan Equity Premium Income Fund (JEPIX), Global X S&P 500 Covered Call ETF (XYLD) and Blackrock Enhanced Equity Dividend Trust (BDJ) are top funds in their respective fund types and yield between 7.51% and 11%.

By taking some of their stock allocation or even their bond holdings, fixed income-focused investors can get potentially higher yields while still realizing some of their equities upside. Moreover, the options strategy smooths out returns to be much more fixed income-like overall.

The bottom line is that fixed income investors don’t have to be afraid of equities. There are ways to hold stocks while still enjoying the stability of bonds. Covered calls are one such way.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.