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Option strategies as an income-enhancement tool

by | Oct 6, 2017 | SELF-PUBLISHED

What’s a “covered call write” and how do managers use it?

Portfolio managers increasingly use stock options to enhance income, using something called a “covered call writing” strategy. But to many investors this sounds mysterious and slightly risky. In fact, when used properly, the strategy can help investors boost income and manage risk. Here’s how it works.

A stock option is simply a contract allowing the holder to buy a stock (a “call” option) or sell a stock (a “put” option) at a specified price (the “strike price”) within a given time. Purchasing an option is often used by investors as “insurance” to protect a profitable position against a drop in share price (put) option, or to acquire shares at set price, often used during a bullish run, allowing the option holder to acquire shares at a price lower than the prevailing market price.

Because an option represents a claim on the underlying stock, it has value as an asset, and its price is referred to as the option “premium.” However, this value gradually decreases as the option approaches its expiration date. If the option isn’t exercised by the holder before the expiration date, either to acquire (call) or to sell (put) the stock represented by the specific contract, the value of the option drops to zero and it expires worthless. Note that there’s no obligation to exercise the option contract. The option contract simply represents the right to make a claim on the underlying stock.

The value of the option contract may be larger or smaller, depending on the price of the underlying stock and the time left before expiration of the option contract.

Where things get interesting is that option contracts may be either bought or sold (“written”) by investors. So, for example, when you “write” a call option on shares you own (writing a “covered” call), you are in effect offering the buyer of the contract the right to buy the shares of your stock at a certain price within a certain time. For this right, the buyer of your call option pays you the “premium,” which is determined by market pricing.

Portfolio managers frequently use the strategy of “writing covered call options” to generate additional income on shares they believe are not likely to move up significantly. The idea is that if the share price remains below the strike price of the call option, the option will not be exercised, and the investment portfolio adds the price of the premium received to the net assets of the portfolio. If the price of the shares rises to the strike price, the shares will be called away, and the stock position will register a capital gain, plus the premium received. The mirror of the covered call strategy is the put write strategy.

There are many permutations and combinations of these strategies, and things can get quite complicated. Many fund sponsors now offer mutual funds and ETFs that use sophisticated covered call or put write strategies as part of the investment strategy their funds. For some, the option strategy is a defining characteristic. In addition, the strategy is used successfully in more sophisticated actively managed pools and private accounts with access to top-flight options specialists.

For self-directed investors, though, option strategies definitely come with risks, and they aren’t necessarily recommended for everyone. As a result, I strongly recommend you consult with your financial advisor before using option strategies on your own (especially if you are a novice) or before investing in a fund that uses options as a core investment strategy.

© 2017 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

© 2021 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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