Boosting investment income with a covered call strategy
How to execute a covered call strategy and when it makes sense.
I’ve recently written several articles on income investing. In response many investors have shared their own experiences and some have talked about using covered calls to generate income. Given the fact that investors are using this approach I thought it was worth exploring this income strategy.
To explain the strategy requires an overview of options. An option is a derivative. That means it derives its value from the value of something else. If an option is on an individual share the value of the option will change based on the value and attributes of the underlying share.
Buyers of options
The buyer of an option has the right, but not the obligation, to sell or buy shares during a specified period of time. Options come in two flavours. A call option gives the holder the right to buy shares. A put option gives the holder the right to sell shares.
A real-life example brings this concept to life. If I am the buyer of a call option on CBA shares at a strike price of $120 which expire on February 15th 2024 I have the right but not the obligation to buy 100 CBA shares for $120 prior to the expiration date. Each option contract is standardized at 100 shares.
If prior to the expiration date CBA shares are trading for more than $120 and the cost of the option then the option would be valuable. If the shares were trading for $130 I could buy them at $120 and either immediately sell them for a profit or just hold them knowing I got a good deal. I would never execute the option if the shares were trading for less than the strike price or price I could purchase shares on the open market. If they were at $110, I wouldn’t purchase them at $120 using the option when I could buy them on the open market for less. In this case the option would be worthless.
Writer of option
For each option there are two parties involved. There is a buyer of the option which I’ve explained above. There is also a writer of options which takes the opposite position. The writer of an option is responsible for the other side of the transaction.
If the buyer of a call option chooses to execute the option, the writer of the option must provide the shares at the strike price. If the buyer of a put option chooses to sell the shares the writer must buy them at the strike price.
Something should have stood out when reading the overview of buyers of options and writers of options. The buyer of an option has all the power. They have the right but not the obligation to purchase or sell shares. The writer of an option has no power. They are required to do whatever the buyer of the option decides.
To compensate the writer of an option for relinquishing their decision-making power they receive a cash payment. That cash payment comes from the buyer of the option who is purchasing the power of deciding what to do. The amount of money that is exchanged is based on an option pricing model.
The Black-Scholes Model is used to price options. The model is a bit complicated but the details aren’t important for the purposes of this article. However, it is worth noting that there are five variables that influence the price of an option. They are the strike price of the option (the price you can buy or sell shares), the current share price, the time until expiration, the risk-free rate and the volatility of the underlying share.
Just remember that as the expiration date approaches a call option is only worth anything if the strike price is below the share price and the cost of the option. For a put option the opposite is true. A put option is worth something approaching expiration date if the strike price is above the share price and the cost of the option. That allows you to buy shares at a lower price and sell them at the higher strike price.
Finally, there are two ways we describe the holder of an option. There are naked options when the investor does not own the underlying shares. When the underlying shares are owned it is called a covered option.
Options can be used for many purposes. They can be used to hedge a portfolio or they can be used to speculate on share price movements. Some investors use them to generate income which is what this article will describe.
Covered call strategy
A covered call strategy can be used as a mechanism to generate more income from a portfolio of shares. It can also be used to offset the downside risk of the share dropping. For the income strategy the basic premise is that an investor with a portfolio of shares writes call options on positions within the portfolio and receives cash payments.
How much is received is a function of the options that are written as they relate to the 5 variables in the Black-Scholes Model.
The mechanics of a covered call strategy
There are three scenarios for the share price that will dictate the impact on an investor:
The share price does not fluctuate significantly and stays below the strike price and the cost of the option for the holder of the call option:
This is the best scenario for a writer of a call option who is looking to generate additional portfolio income. The investor gets to keep the shares and gets to keep the payment received for writing the call.
The share price increases above the strike price and the cost of the option for the holder of the call option:
In this case the buyer of the option will execute it and purchase the share from the investor that wrote the call. This is not a great scenario for the investor that wrote the call option. The upside from the underlying share position will be limited to the strike price and the payment received for writing the call. Any additional share price appreciation will be missed as the investor will have to sell at the strike price. If the position has appreciated since it was purchased the forced sale will also trigger capital gains taxes. If the investor was following an income strategy any future dividends from the position would also be forfeited.
The share price decreases significantly from when the option was written:
In this case the option would not be executed and the investor would get to keep the shares and the payment made from writing the call. However, the position would be worth less although there would be downside protection since a payment is received for writing the option. This may or may not be a problem for the investor. If the investor had no intention of selling the shares this change in value will just represent the short-term volatility in the market.
When does a covered call strategy make sense
There are a couple things for investors to keep in mind when considering a covered call strategy. The first is the tax environment and the level of unrealised capital gains on the position the call option is written on. In the super tax environment capital gains are limited to 15% and long-term capital gains are discounted. In the pension phase there may be no capital gains taxes. However, in a taxable environment the costs of being forced to sell an appreciated position are much higher.
It is also important that an investor considering a covered call strategy ensures that it is aligned to the underlying investment strategy. If an investor is focused on capital appreciation writing a call will limit the upside potential of a portfolio. Historically markets tend to go up and limiting the upside may result in significantly lower portfolio balances.
If an investor is only focused on generating income a covered call strategy may make sense if the periodic capital gains taxes don’t eat up too much of the payments generated from writing calls. The other consideration is the possibility of being forced to sell income producing share holdings.
Finally, an investor’s timeline matters. A covered call strategy should underperform a rising market as the upside is capped by the covered call. Over the long-run the market has historically gone up most of the time. The differences in returns may not matter for a short-term investor focused on income. However, those return differences will compound over time which may mean significantly lower portfolio values over the long-term.
Implementing the strategy
One way to get around the risk and the headache of having to write options yourself is to use an ETF. Examples of ETFs that follow a covered call strategy and trade on an Australian exchange are the Global X S&P/ASX 200 Covered Call ETF (ASX: AYLD) and Australian Top 20 Equity Yield Maximiser Fund (ASX: YMAX).
We can compare the YMAX ETF which has a longer history to a traditional dividend ETF such as the Vanguard Australian Shares High Yield ETF (ASX: VHY) which I’ve written about before. Over the past 3 years VHY has generated an annualised return of 12.10% per year vs 10.39% for YMAX. Over a 5-year period the gap widened with VHY at 11.52% vs 8.40% for YMAX. And over a 10-year period the return differential narrowed again with VHY returning 6.86% vs 5.01% for YMAX.
Those returns assume that distributions are reinvested. It is a different picture if we simply look at the price of the ETF and take distributions in cash. Over the past 3 years the ETF unit price of YMAX rose from $7.53 on December 31st 2020 to a price of $7.70 on January 30th 2024. That is only 1.85% higher. Meanwhile, the price of a unit of VHY rose from $57.43 to $70.75 over the same time frame. That is close to 20% higher.
When just looking at price changes for a unit of the ETF and not total return we need to consider the distributions. We can compare how much income would have been earned if an investor had purchased $10,000 of each ETF on December 31st 2020. The investor that purchased VHY would have received a respectable $1,862 in distributions. The YMAX investor would have received $5,672.
This outcome demonstrates the positive and negative consequences of a covered call approach. The unit price of the ETF – or market value of a portfolio using a covered call strategy – may drop over time even as markets rise. In fact, since 2012 when YMAX came into existence the unit price of the ETF is down close to 26%. However, the income earned can be significantly higher which can support an investor who is spending that income. It all comes down to what an investor wants to achieve.
Would I use a covered call strategy
A personal example may bring this strategy to life. I follow an income strategy in my non-retirement accounts. For more on my strategy please see this article. While generating income is my goal, I would not use covered calls at this time.
I wouldn’t do it on the individual holdings in my portfolio as I have mostly appreciated shares that I want to hold for the long-term. Being forced to sell these long-term positions if the option is executed is not something I want to risk. The shares in my portfolio are the mechanism I use to generate income over the long-term. I also want to avoid the high levels of capital gains taxes I would owe.
An ETF is a more intriguing option. However, the reason I invest in dividend paying shares is not simply to collect income. There are studies that indicate that dividend paying shares produce higher returns with less volatility than the overall index. I cover those studies in this article articulating why I’m an income investor.
I am still relatively young and I want both the benefit of income earned and share price appreciation. When I reach retirement I may adjust this approach to generate more short-term income. That might be a time I would use covered calls.
If you are using a covered call strategy I would love to hear from you. Please email me at firstname.lastname@example.org