For investors hoping to juice up the income from their stock holdings or preserve capital, covered calls could be an effective and relatively low-risk way to accomplish those goals.
In its most basic terms, a covered call is an options strategy where investors sell a contract to buy shares they already own. For example, an investor who owns Microsoft Corp. (ticker: MSFT) could sell a contract allowing another investor to buy their Microsoft shares at a set price before the option expires.
[Sign up for stock news with our Invested newsletter.]
Before jumping into the use of covered calls, there are some basic terms to understand:
— Strike price. The price at which an option holder can buy or sell a stock.
— Out of the money. A call option is said to be “out of the money” if its strike price is higher than the price of the underlying stock.
— At the money. An option with a strike price that is the same as the price of the underlying stock.
— Premium. An option premium is the price paid by an investor to the seller of an option contract.
“For income-focused investors, covered calls offer a way to enhance portfolio returns by collecting premiums, especially when applied to stable or moderately volatile stocks. This can create a steady income stream, regardless of market conditions,” says Si Katara, founder and CEO of TappAlpha in Seattle.
The company’s TappAlpha SPY Growth & Daily Income ETF (TSPY) uses a daily covered call strategy to capture the growth potential of the S&P 500.
“For those more focused on capital preservation, covered calls can provide a degree of downside protection. The premiums collected from selling calls can offset some losses if the underlying stock declines, effectively reducing the overall cost basis,” Katara says.
However, he adds, the trade-off is that the upside potential is capped by the strike price of the call.
A Relatively Simple Options Strategy
Although it comes with some of its own unique terminology, a covered call is actually one of the most simple options strategies to execute. Think of an options trade as “renting” a stock for a lower price than you’d pay to buy.
If the stock moves higher, so will the call option. The same is true if the stock moves lower.
Investors use calls if they are bullish about a stock and want to generate income by capturing the stock’s upside move, but at a lower cost than buying the shares. An investor in a stock that has options can sell one call option for every 100 shares owned.
Here’s how that might work: Say you own a stock currently trading at $40. You could sell a $45 strike call with a certain expiration date, since you expect the price to rise by $5 by then.
When you sell a covered call, you get a premium that’s deposited into your account right away. You keep this no matter whether the underlying shares move up or down by the expiration date.
The premium amount will vary and is tied to factors including the strike price and expiration date. Market volatility can mean higher premiums, as that creates higher potential for either gain or loss.
In addition to the premium, you’ll keep whatever the stock returns before the expiration date, up to $45.
If the call expires out of the money, you could sell another call at an expiration date that’s further out, and even at a different strike price.
[SEE: 7 Best ETFs to Invest in Corporate Bonds]
Best Stocks for Covered Calls
So what kind of stocks should investors be considering for a covered call strategy?
“The best stocks for covered call income are high-volatility, high-priced stocks that are trending directionally up,” says Mike Venuto, co-founder and chief investment officer of Tidal Financial Group in New York.
Venuto uses Nvidia Corp. (NVDA) as an example. “It has a relatively high stock price, which allows for more cost-effective use of options. It has trended up, allowing for a stable share price, and has high volatility.”
Tidal is the investment advisor to YieldMax, whose exchange-traded funds include the YieldMax NVDA Option Income Strategy ETF (NVDY). This strategy aims to create monthly income by selling call options on Nvidia. It does not own the underlying stock.
That ETF generates a high level of income, as well as capturing some gains from upside price movement.
Which Investors Should Use Covered Calls?
Investors should be aware that covered call strategies, while fairly simple to understand, are not suitable for everyone and in every situation.
“Tech stocks and higher volatility stocks produce more option income, but large, established companies with strong balance sheets and regular dividends provide a more reliable income,” says Stefan ten Brink, managing director at Van Hulzen Financial Advisors in El Dorado Hills, California.
He cautions that self-directed investors using a covered call strategy should be sophisticated enough to have a thorough understanding of options trading.
For investors who want a “done for you” strategy, for any number of reasons, ETFs such as those run by TappAlpha and Tidal may be a sound choice. Those companies market their products to financial advisors to implement in client portfolios.
Katara says TappAlpha’s TSPY ETF is designed for long-term, self-directed investors who want to enhance portfolio performance with additional income that could potentially allow them to outperform benchmarks while also managing volatility.
“While the strategy involves daily options and covered calls, which can seem complex, we’ve designed it to be accessible. Investors don’t need to be experts to benefit, but they should have a foundational understanding of the markets and be comfortable with the concepts of income generation and risk management,” he says.
The idea is to give do-it-yourselfers a way of accessing options strategies also used by professional investors.
How Financial Advisors Can Use Covered Calls
Some financial advisors use covered call strategies for certain clients. ETFs can make that process easier.
“When working with the financial advisor community, we generally recommend a diversified basket of covered calls rather than just a single stock strategy,” says Venuto.
He points to two other ETFs that use a strategy of diversification:
“A good example is QQQY from Defiance ETFs, which uses daily options to generate income from the Nasdaq 100 Index,” he says. That ETF is constructed using Tidal’s strategies.
Another diversified approach using Tidal research and technology is the YieldMax Universe Fund of Option Income ETF (YMAX), which is a fund of funds that owns single-security ETFs. Holdings include options strategy ETFs for stocks such as Alibaba Group Holding Ltd. (BABA), MicroStrategy Inc. (MSTR), Advanced Micro Devices Inc. (AMD) and Exxon Mobil Corp. (XOM).
“These products are great complements in an income or alternative income sleeve of a portfolio,” Venuto says.
He notes that investors who own a single stock can use covered calls to complement that existing long position. For example, investors who have a large position in Apple Inc. (AAPL) but would like additional yield could replace a portion of the Apple stock with the YieldMax AAPL Option Income Strategy ETF (APLY).
When working with financial advisors, Katara says his firm recommends using ETFs to implement a covered-call strategy for clients seeking a balance between income and growth.
“Advisors often find it appealing for investors with longer time horizons that are looking for additional income opportunities without taking on significant new risk,” he says. “Our strategy works well for investors looking for consistent income generation while still maintaining exposure to the broader market.”
More from U.S. News
7 Best Monthly Dividend Stocks to Buy Today
7 High-Yield Covered Call ETFs Income Investors Will Love
What’s the Best Covered Call Strategy for Income? originally appeared on usnews.com
