Even bonds, usually thought of as a safe haven for investors, lost their value as interest rates spiked, given the inverse correlation between interest rates and bond prices.
In this environment, investors saving for retirement may want to consider a different approach to boost their income. One strategy that could help is to use a covered call writing strategy. Before we explore that, though, let’s look at the financial instrument the strategy uses: call options.
What is a call option?
A call option is an agreement between two parties that gives the option buyer the right, but not the obligation, to buy a stock at a certain price (the “strike price”), within a specified time frame. The buyer pays a fee, called a premium, to the seller for that right. The seller keeps the fee regardless of what happens later.
The option is “covered” if its seller owns the underlying stock, meaning they can fulfill the contract without having to later buy shares. If the seller doesn’t own the stock, the option is “naked.”
How a call option works
Let’s say you buy a call option contract that allows you to buy one share of a stock at $50 for the next 30 days. You pay the seller a $2 premium to lock in the stock price for that period.
If the stock price rises to, say, $55 during those 30 days, you can “exercise” the option and buy the stock at $50, the original price. Your total cost would be $50, plus the $2 premium—$52 in total—for a stock that’s now worth $55. You can either sell the stock for a $3 profit or hold on to it. Conversely, if the stock price falls to $45, you can let the call option expire without buying the stock. Your only cost is the $2 premium.
Call options can offer a number of benefits to investors, including:
- Income generation: When used in a wrapper like an ETF, the strategy can be a useful tool for higher cash flow. If you invest in an ETF that sells call options on some of its portfolio holdings, it can generate premiums in an up or down market. Those premiums can provide additional income to you, the unitholder.
- Downside protection: A call option strategy inside an ETF also reduces a portfolio’s volatility because the premium protects against the downside. In fact, when implied volatility is higher, premiums are higher too, benefiting a call option seller.
- Tax efficiency: Call options can be a tax-efficient way to generate income. The covered call option premium—cash flow received from writing a call option—is considered a capital gain. Capital gains tax is lower than the tax on interest and on dividend income. So, using covered calls is a tax-advantaged investment strategy.
Call options and investing for retirement
Call options can be a useful tool for retirement investing because, on the one hand, they can provide a way to enhance income and potentially increase returns, while on the other, they provide downside protection during volatile periods.
Vikram Barhat
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