This Article Appeared in Kiplinger's Magazine.
During times of uncertainty, an investor can use a covered call to deliver downside protection while capturing upside gains.
Here’s how it works.
The headlines surrounding today's markets are scary: stubborn inflation, rising interest rates, bank crises, a possible recession and other economic perils. However, the markets have proven to be resilient so far. While trying to time the market is never prudent, it makes sense to assume a defensive posture, given the current conditions. The risk of a market downturn is higher than the potential opportunity cost of missing a significant move to the upside.
Markets are currently pricing in a rate cut before the end of the year, but inflation remains difficult for the Fed to contain. The Fed is indicating a pause in rate hikes, and the markets expect a cut before the end of the year. In addition, the stock market's breadth is weak, with the S&P 500's average stock showing little change, while mega-cap tech stocks like Apple and Microsoft have experienced strong rallies. This concentration of gains in a few stocks is generally not a good sign for the overall market.
Several economic indicators suggest that a recession may occur this year. Corporate earnings are declining due to rising costs, weakening revenues and longer sales cycles, with leading tech firms such as Amazon and Salesforce reporting reduced customer spending. Valuations remain high relative to historical averages, while the money supply is shrinking due to higher interest rates, banking concerns and tighter credit. Inverted yield curves, where short-term interest rates are higher than long-term rates, have historically preceded recessions and are currently observed across various Treasury durations.
The markets have never bottomed before a recession starts. Therefore, it is prudent to consider strategies that provide a buffer against a downside move while also offering the opportunity for capital appreciation if and when the market moves higher. A covered call is among the proven strategies to deliver downside protection while capturing upside gains.
What are covered call strategies?
Covered call writing strategies are considered a low-risk type of options transaction, and they are relatively easy to implement. While it is often not advisable for the average investor to try to execute a strategy like this on their own, there are professional managers specializing in this area. In addition, some mutual funds and even ETFs (exchange-traded funds) are available and easy to purchase to allocate a portion of your overall portfolio to a strategy like this.
Here is how it works: Writing a covered call means you sell the right for another party to buy your stock at a specific price. A covered call means that you are writing a call against a stock you currently own.
For example, let's say you own Merck stock with a current price of $115 per share. You may decide to "write a call" on the Merck stock at $117. This means you are selling the right for another party to purchase your Merck stock from you at $117. In exchange, the other party must pay you a premium. For this example, let's assume you receive $1.19 per share in premium to sell someone this right for 30 days. That additional money goes into your account.
These contracts usually expire within a short time frame, often 20 to 30 days. If Merck stock stays flat or declines during that time, nothing happens. You keep your stock, and you get to pocket the additional premium you received for entering into this contract. You could enter into another contract the following month and receive additional premium payments.
If Merck stock increases to, say, $125, the other party would "exercise" their right to buy the stock away from you. That is the tradeoff — you could have your stock bought away from you right when a rally takes hold, and you would miss all of that upside. For this reason, you write call options when you expect the price of your stocks to remain flat or decline during the contract period.
That brings us to the current environment. If you are concerned about the market remaining flat or declining, you could decide to generate some additional income on your portfolio and get "paid to wait" for the markets to start a new, long-term uptrend.
What are the benefits and drawbacks of covered call strategies?
The primary con is that if the market rallies sharply, you may not fully participate in the rally. Strategies like this tend to focus on dividend-paying companies, and they may lag when growth stocks are in favor.
With that said, this is one of the few areas of the market where you can generate enough income to outpace the rate of inflation. If you are retired and in need of income, the money generated can be used to meet your monthly living expenses.
If you do not need the money to spend right now, you can simply reinvest the income, and that invested income buys more shares, which produces more income. So you now have a powerful compounding effect that could be highly beneficial over time. Also, if the market does dip, you are reinvesting at lower market prices, which is great for long-term investors.
In summary, covered call strategies offer a compelling investment option for investors seeking to enhance their income streams, capture potential capital appreciation and protect their portfolios during uncertain times.
Of course, as is often the case, it is wise to consult with a financial adviser to determine if a covered call strategy suits your investment goals and risk tolerance. However, when appropriately used as part of a well-thought-out investment strategy, it may give you the confidence to stay invested while weathering any near-term storms on the horizon.