Using basic option strategies provides an opportunity to generate income, reduce volatility and produce bond-like returns for portfolios.
For fixed income investors, using covered calls on their stock sleeve has the ability to enhance the performance of their overall bond sleeve and provide plenty of sleep-at-night comfort. The best part is that using options continues to get less complicated for retail investors.
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Covered calls or a buy-write is one of the simplest options strategies to use. Here, an investor buys a stock or a basket of stocks tied to an index and writes call options that cover the position. A call option gives its holder the right to buy a stock from the option seller at a certain price by a certain date.
The option writer collects a fee for agreeing to the transaction, which becomes theirs no matter what. At the same time, they can keep the stock and collect the dividends it generates. However, if shares of the stock or ETF go past the strike price of the option, the option buyer will get to buy the shares. However, if it never gets to that point, the option expires worthless and the option writer gets to keep the shares.
For starters, using covered calls creates more income from a stock portfolio. Because of the option premium that sellers get, in addition to the dividends generating from the stock, using the strategy can effectively double or triple the yield a stock produces. In the current environment, this puts many yields from stocks and equity indexes above fixed income yields.
Additionally, using a buy-write and covered call strategies reduces volatility and lowers risk. Because of the strike price, upside is capped. But the option premium that writers collect can help limit losses. This tight band of returns tends to be stable, much like a fixed income portfolio. Overall, the long-term volatility of the major benchmark – the CBOE S&P 500 Buy Write Index – is about 30% lower than the S&P 500 alone. Moreover, the long-term returns for the index are solid. And, in fact, from the 1980s through the Great Recession, the buy-write index managed to outperform the bread & butter S&P 500. It was only in the recent zero interest rate environment that the relationship switched.
By using a covered call strategy, fixed income investors can still stay invested in the stock market and produce returns similar to their bond investments. With that, some analysts have suggest that covered calls be a main piece of a 60/40 fund and cover most of the stock sleeve.
However, buying a fund may be a better choice. And there are plenty of ways to do so, either via a mutual fund, ETF or closed-end fund. For example, the JPMorgan Equity Premium Income Fund (JEPIX), Global X S&P 500 Covered Call ETF (XYLD) and Blackrock Enhanced Equity Dividend Trust (BDJ) are top funds in their respective fund types and yield between 7.51% and 11%.
By taking some of their stock allocation or even their bond holdings, fixed income-focused investors can get potentially higher yields while still realizing some of their equities upside. Moreover, the options strategy smooths out returns to be much more fixed income-like overall.
The bottom line is that fixed income investors don’t have to be afraid of equities. There are ways to hold stocks while still enjoying the stability of bonds. Covered calls are one such way.
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