Creating Income in Volatile Markets

02/10/2009 12:00 pm EST

Focus: OPTIONS

Bryan Perry

Editor, Cash Machine, Premium Income, Quick Income Trader, Instant Income Trader

Bryan Perry, editor of The 25% Cash Machine, says covered call writing is a good strategy in a volatile market like this, and he recommends two funds that do it well.

One of the most versatile tools an investor can use to generate income is through covered call writing, or the selling of covered calls on existing positions.

A call option gives the holder the right, but not the obligation, to buy 100 shares of the underlying stock at a specified price—called the strike price or exercise price—for the life of the option—typically one month to a year out. If you own the stock and it declines, you still own the stock and have time on your side. But not with options.

The flip side of options trading is that you can sell that inherent risk back to the market in the form of covered call writing. Selling covered calls is a conservative option strategy used by investors to realize additional returns on stocks while creating portfolio insurance—a hedge that partially protects against price declines.

By selling covered calls, the writer, or seller, of a call has the obligation, if exercised, to deliver 100 shares of the underlying stock at the exercise price until the expiration of the option. In other words, you are selling the right for someone else to buy your stock away from you at a given price for a given period of time. So, by assuming this obligation, the seller of covered calls collects the premium in the form of cash as payment for selling the ownership rights of stock at a given price for a given period of time.

To engage in covered call writing, instead of buying that call option on IBM (NYSE: IBM), we buy the stock and sell that same call option to some buyer. Assuming we pay that same $92 for 100 shares of IBM, we then sell one IBM 90 call for $600, but we keep the $600 and are willing to lose our 100 shares of IBM at $90 if the stock is trading above that level when the call expires. We lose two points on the stock, but make six points on the call option for a net gain of four points, or 4% on our $9,200 invested.

If you do that four times a year, you would theoretically enhance your yield by 16%. That’s assuming IBM behaves itself and doesn’t implode, because taking in four points is meaningless if a $92 stock crashes by 50%. Remember, the major risk in covered call writing is that the stock may decline much more than the protection provided. But in rebuilding portfolios at market bottoms, it’s a strategy that is very effective in a volatile market.

When effectively utilized, the writing of covered calls is an important portfolio tool that has a strong place amongst our holdings. Currently, we own [several] funds that employ a covered call strategy of some kind. They include BlackRock Enhanced Capital & Income Fund (NYSE: CII) and Nuveen Multi-Currency Short-Term Government Fund (NYSE: JGT). It’s one way we keep the cash coming in.

Subscribe to The 25% Cash Machine here…

Related Articles on OPTIONS