As the stock market’s period of slow growth drags on, many investors have become frustrated by the lack of portfolio returns.
But there’s a sensible, conservative way to potentially add a bit more to returns. It’s known as a covered-call strategy, and it has been effective for us at Steel Peak. The most straightforward covered-call strategy is to enter into a contract with another party to sell shares of a stock you own at a predetermined “strike” price.
In exchange for agreeing to potentially sell the stock, you are paid a premium. And over time, these premiums can produce a meaningful amount of income for your portfolio. The strategy can be particularly effective when markets are flat or falling.
Of course, any investment strategy involves risk. In the worst-case scenario, those selling covered calls must sell their shares and miss the chance to pocket their stock’s appreciation.
Here’s an example of a popular covered-call strategy in action. Let’s say you own 1,000 shares of Acme Corp., and those shares are currently valued at $30 each. Based on Acme Corp.’s fundamentals and growth prospects, it doesn’t appear that the stock’s price will jump significantly within the next six months.
So you decide to sell “calls” on 10, 100-share lots of your Acme stock. Specifically, you’re agreeing to sell the stock at its low current price ($30 per share) once it climbs to a specified “strike” price—let’s say $40.
In exchange for the right to potentially buy appreciated stock on the cheap within the next six months, your buyer agrees to pay you, let’s say, $1.50 per share. If the stock hits $50, your buyer wins: He can exercise his buy option, and you must hand over the stock for $30 per share. If the price does not hit that level, you keep the premiums free and clear. And if the price rises within the six-month window of the contract, but not to the $50 level, those gains are yours to keep.
Bear in mind that a covered call strategy can be repeated once the specified time period ends. So successful execution can have a cumulative effect. And of course covered-call writers retain dividend rights on their underlying stock.
As the owner of the stock, you can control the level of risk in your covered-call strategy based on the strike price you set. The caveat is that the higher the strike price, the smaller the premium you’re likely to command.
It can be a good idea to use a covered-call strategy within a tax-advantaged account such as a traditional or Roth IRA. That’s because selling a stock (if it does hit its strike price) will not trigger tax consequences. And any additional income generated can be reinvested in the portfolio.
Writing covered calls is complex and does entail risk. But in the hands of experienced professionals, it can be an effective method of generating extra investment income in stagnant markets. Please contact us if you’d like to learn more about our investing approach, including our use of covered calls to generate extra income.