Generating Income: Covered Call Writing Strategy

On this week's edition of The Clark Group Planning Minute, we will be discussing an income producing options strategy known as a covered call writing strategy.?

A covered call writing strategy is an options strategy where an investor holds a long position in an underlying asset, such as stocks, and simultaneously sells call options on that underlying stock position. We have seen clients over the years who have built up a large, concentrated position in their employer stock (or even other publicly traded stocks not correlated to their employer), typically through stock compensation benefits. These clients may have too much of their retirement assets tied up in one stock, and instead of just selling a portion or all of the stock position at one time, utilizing this covered call writing strategy is a way to potentially hedge risk, while collecting income.

To start, a buyer of the call option gives them the right, but not the obligation, to buy the underlying stock from the seller at a predetermined price (strike price) within a certain window of time (expiration date). On the opposite side, you have a seller of the call option which grants them the obligation to sell the stock if, and only if, the stock price goes at or above the strike price.

In a covered call writing strategy, the investor earns income by collecting the premium from selling call options, while also potentially benefiting from any increase in the value of the stock going up. If the price of the underlying stock rises at or above the strike price, the call option may be exercised, and the investor is obligated to sell the underlying stock at the strike price, potentially missing out on further gains. However, if the price of the underlying stock stays below the strike price, the call option would not be exercised, and the investor keeps the premium income and the same stock position. This strategy is viewed as a slightly bullish (positive) to neutral position to the stock and can be somewhat of a short-term hedge on a long stock position. When doing options, each contract is worth 100 shares, so in order for an investor to do this type of strategy effectively, they must have at least 100 shares of the underlying stock.

A couple examples as to why you may want to use a covered call writing strategy would be when the stock has stayed about the same in price for a few months or even years, and your goal is to collect extra cash flow on the stock position. Another reason to deploy this strategy is if you experienced a significant increase in stock price recently, and you are happy with diversifying a portion out of the stock by selling the stock at a higher price (strike price) if it increases even further. Keep in mind, if the underlying stock pays a dividend, you still get to collect the dividend while holding the stock.

Let's use an example where you hold 4,000 shares of Johnson & Johnson (JNJ) stock and it is trading at $160 per share for a total of $640,000. Even though you may think J&J is a great company and long-term stock, you might not want a majority of your retirement portfolio in one stock experiencing significant price swings, especially if you are close to retirement or are already pulling funds from that account. Of course, everyone's goals and objectives are different, but it may be prudent for your situation to only hold 1000 shares and diversify the rest into a basket of stocks like an S&P 500 index fund. Instead of just selling the 3,000 shares to get you down in position size to 1,000 shares, you can generate income off of the stock by selling 30 JNJ call options (remember, each contract is worth 100 shares) until it gets called (sold) away. As of this writing, JNJ stock pays above a 2% dividend, so the premium from the call options + the dividend from the stock can bring in extra income to the portfolio. That can really help increase the income you receive in your portfolio while still providing a hedge.

Finally, utilizing this strategy in a tax-advantaged retirement account, such as an IRA, can provide tax benefits. The reason for this is that if you use this strategy in a taxable brokerage account, the income you receive through the premiums are taxed as ordinary income. However, in an IRA (or Roth IRA), the income generated from the premiums are not taxable.?

Overall, the covered call writing strategy can be useful for investors looking to generate income while still benefiting from potential stock price appreciation, but it does come with some risks and limitations that should be carefully considered. Speak with your fiduciary advisor to see if this type of strategy may make sense for you.

The information in this article is solely informational and is not intended to be legal or tax advice. Please consult your fiduciary financial advisor or CERTIFIED FINANCIAL PLANNER??before implementing anything discussed in these articles.

For important disclosures, please visit: clarkgroupam.com/disclosure