Many investors share with us that they are income investors. Some used covered call strategies to boost income. 

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.

To understand how it works, we started with an overview of options. Then, who a covered call strategy may suit. Lastly, we spoke about the historical returns of a covered call strategy compared to traditional strategies that sought high yield. 

You can also find a full article here.

Listen on:

Get Morningstar’s insights in your inbox each morning. Sign-up for our email newsletters.

You can find the transcript to the episode below.

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

LaMonica: All right. So, Shani, we're going to talk about quickly your stalking skills.

Jayamanne: Yeah.

LaMonica: You always said that you were very good at stalking people online.

Jayamanne: Don't make me sound creepy.

LaMonica: Okay. Well, anyway, people can take that as they will. But I've been playing squash for a while, and I've talked about it on here. Incidentally – so I play with an 83-year-old squash coach.

Jayamanne: Ollie.

LaMonica: Yes, Ollie. Ollie the other day at my lesson said that he is going to turn me into a great squash player by the time I'm 30.

Jayamanne: So, Mark has told me this story like five times now.

LaMonica: I know. It's very exciting. And I was like, Ollie, are you going to get a DeLorean because I'm 45 years old? And he was very surprised. He thought I was 28.

Jayamanne: Well, there you go.

LaMonica: But that's because he is 83.

Jayamanne: Yes.

LaMonica: It's like when I go to the pub and there's an 18-year-old in there, I always think they look like they're 14.

Jayamanne: But he thinks he looks like 55.

LaMonica: Exactly. But anyway, I've been playing with him.

Jayamanne: But you're going to play other people now.

LaMonica: I know. And I announced on here, does anyone want to play squash? Nobody took me up on the offer. But I'm going to play other people. And I got sent around the email addresses of the little group I'm going to play with. And Shani stalked every single person in there.

Jayamanne: Yes. And we wanted to see how much of a threat they would be and then find things about them that Mark could sledge them with.

LaMonica: Yeah. So, it's going very well.

Jayamanne: Yes.

LaMonica: But anyway, why don't we get into the topic? And we're going to cover a bit of a niche topic today. But I do know that some investors pursue this strategy.

Jayamanne: So, when you say niche topic, do you think that the only people who will listen to this are Luke, the person we went to lunch with and had the (indiscernible) bag away and your mother?

LaMonica: Yeah, probably.

Jayamanne: And maybe your new friends at the squash court?

LaMonica: Well, hopefully not. Or they'll want to know why you stalked them. But maybe this is an episode that will resonate in the stands and in the African countries where we don't have any listens yet.

Jayamanne: Yeah, I hope so. I mean, maybe we'll hit a new country or get our second listen in the Democratic Republic of Congo, where we only have one listen.

LaMonica: Yeah. Which isn't great. I don't know what your thoughts are on this, Shani, our presence in the Democratic Republic of Congo.

Jayamanne: I don't have any particular thoughts, but we should warn you that this episode is definitely different to our usual ones. It is quite dense, so please stick with us. We'll take it nice and slow.

LaMonica: Okay. So, we are going to talk about a covered call strategy. And that's something that investors use to boost income in their portfolio. And I do know that people like income. But before we get into this, we need to talk a bit about options because a covered call strategy involves options. So, Shani, why don't you start us off with a discussion about the buyers of options?

Jayamanne: All right. So, 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 choices. A call option gives the holder the right to buy shares. A put option gives the holder the right to sell shares.

LaMonica: All right. So, let's do a real-life example to bring this concept to life. So, if I am the buyer of a call option on CBA shares at a strike price of $120, which will expire in one month, I have the right, but not the obligation to buy 100 CBA shares for $120 prior to the expiration date. And each option contract is standardized at 100 shares. So, if prior to the expiration date, CBA shares are trading for more than $120 and the cost of the option that would make the option valuable. Shares are 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 the price I could purchase the shares on the market. So, if they are $110, I wouldn't purchase them for $120 using the option. In this case, the option would be worthless.

Jayamanne: For each option, there are two parties involved. There is a buyer of the option, which we've spoken about. There's 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.

LaMonica: Okay, so we're going to quickly go through option pricing. And something that should have stood out during this overview of buyers of options and writers of options is that 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.

Jayamanne: To compensate the writer of an option for relinquishing their decision-making power, they receive a cash payment. The 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's pricing model.

LaMonica: And the Black-Scholes model is used to price options. Now, the model, as you can probably imagine, is a bit complicated. The details aren't really important for the purpose of this podcast. However, it's worth noting that there are five variables that influence the price of an option. They are the strike price of the option, that's 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 shares. So that was obviously a lot. But 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. Or a put option, the opposite is true. Put option is only worth something approaching expiration date if the strike price is above the share price and the cost of the option. Because that, of course, allows you to buy shares at a lower price and then sell them.

Jayamanne: And 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 we're going to talk about during this podcast.

LaMonica: Okay, so deep breath, Shani. We did it. We got through options one-o-one. Now we need to get into the meat of the podcast, of course, if anyone is still listening.

Jayamanne: Highly doubtful.

LaMonica: Exactly. And an interesting point, I was thinking about putting our podcast into the Australian Podcast Awards competition, but it costs $340, Shani, to submit a podcast, which seems like a lot. But…

Jayamanne: Do you think that we could cover it with what we've made on our Christmas shares?

LaMonica: I mean, probably not.

Jayamanne: Probably not.

LaMonica: Yeah, maybe. But I could enter in the Sri Lankan podcast competition if there is one. I don't know if you know.

Jayamanne: I don't.

LaMonica: Because we were the number one investing podcast in Sri Lanka in May of 2023.

Jayamanne: I wonder why they're listening to us.

LaMonica: Don't you assume this is just your relatives?

Jayamanne: Maybe, maybe.

LaMonica: Probably not.

Jayamanne: But why don't we get back to this so we can regain our position?

LaMonica: Okay, there we go. I know that the Sri Lankans listening are interested in the covered call strategy.

Jayamanne: Well, something that Sri Lankans could also be interested in is something my mother told me. Like this is like your age story. I've repeated this story a lot because it's a great story.

LaMonica: You're related to some famous cricket player.

Jayamanne: Sangakara, who was a great batsman and wickets keeper, but only by marriage. But I'm keeping that bit out for everyone that asks.

LaMonica: Well, there we go. And luckily, nobody is listening to this podcast anymore. All right, we're going to talk about covered call strategy now.

Now, that is a mechanism to generate more income from a portfolio of shares. It can also be used to offset the downside risk of share prices 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 of course, receives those cash payments. How much is received is a function of the options that are written, as they relate to those five variables we went through in the Black-Scholes model.

Jayamanne: We'll go through the mechanics of a covered call strategy. There are three scenarios for the share price that will dictate the impact on an investor. So why don't you take the first one, Mark?

LaMonica: Well, thank you, Shani. That's very nice of you. You can keep googling this cricket player. The first scenario is 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.

Jayamanne: The second scenario is 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 that 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 for 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.

LaMonica: The last scenario is when 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 call or writing the option. This may or may not be a problem for the investor. The investor had no intention of selling the shares. This change in value will just represent the short-term volatility in the market.

Jayamanne: The question of course for any investor is when a covered call strategy makes sense. There are a couple of things for investors to keep in mind when considering a covered call strategy. The first is the tax environment and the level of unrealized 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.

LaMonica: And of course, the second consideration is we want to make sure that if you do use a covered call strategy, it's aligned to your underlying investment strategy. But investors 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, 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 shareholdings.

Jayamanne: And 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.

LaMonica: All right. So, we're on a roll, Shani. And if people are still listening, they must be interested in a covered call strategy or the fact that this cricket guy is somehow related to you.

Jayamanne: Or just the soothing sounds of Kermit the Frog's voice. This is probably one of the heavier podcasts that we do.

LaMonica: Thank you for that. I'll just ignore that. All right, we're going to talk about how to implement this strategy. One way to get around the risk and the headache of having to write options yourself is to use an ETF. So, 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 with the ticker symbol AYLD and the Australian Top 20 Equity Yield Maximiser Fund with the ticker YMAX.

Jayamanne: 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 with the ticker symbol VHY. Over the past three years, VHY has generated an annualized return of 12.1% per year versus 10.39% for YMAX. Over a five-year period, the gap widened with VHY at 11.52% versus 8.4% for YMAX. And over a 10-year period, the return differential narrowed again with VHY returning 6.86% versus 5.01% for YMAX. Those returns assume the distributions are reinvested. It's a different picture if we look simply at the price of the ETF and take distributions in cash. Over the past three years, the ETF unit price of YMAX rose from $7.53 on December 31, 2020 to a price of $7.70 on January 30, 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 timeframe. That's close to 20% higher.

LaMonica: And 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 31, 2020. The investor that purchased VHY would have received a respectable $1,862 in distributions. The YMAX investor would have received $5,672.

Jayamanne: So, 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.

LaMonica: All right, we did it.

Jayamanne: We did it.

LaMonica: We made it through the podcast. And that right there, folks, is why this is the number one investing podcast in Sri Lanka, or at least was for a week.

Jayamanne: I mean, you're not supposed to have favorite children, right? So, you're not supposed to have favorite podcast episodes, but I can definitely say this is probably not at the top of my list.

LaMonica: Well, there we go. All right. Well, thank you for listening. If this is your favorite podcast episode, send me an email. My email address is in the podcast notes, and I'll pass it on to Shani so she can realize that this was a great topic. But thank you very much for listening. We appreciate it.