Getting Started in Covered Calls

12/07/2012 10:00 am EST


John Pearce

, Van Hulzen Asset Management LLC

John Pearce talks about basic covered call strategies, and what new covered calls investors should watch for in this market.

Will investors know that covered calls are a way to increase your returns on your overall portfolio? Are investors still using it? Who is it appropriate for these days? My guest today is John Pearce to talk about that. So, John, let's talk about the covered call strategy. Are more people using it today than ever before?

You know, I think they are. They are becoming more familiar with the strategy, and there is a good reason for that.

Investors are income starved. They are looking for sources of yield and it's a tough environment. Right now, you've got ten-year yields of about 1.5% on Treasuries. Dividend yields are 2%, whereas the 100-year average is more like 4% or 5%. It's very hard to find yield.

So investors have a couple of options. They can move out in the credit and move up to say high-yield bonds, but they are obviously taking on additional credit risk when they do that...but you can get maybe 6% to 7% yield still in that category. Or you can learn about covered calls.

It's a great way to add some incremental income to your portfolio and call it instead of a 2% yield, maybe 7% or 8%, and trade some of the uncertain price appreciation that's associated with stocks for a lot more certain current period income.

Alright, let's talk about who can do this and who is sort of the right candidate and then how you implement this into a portfolio if you're just getting started. What do you do?

Yeah. Any investor who is comfortable owning stocks in their portfolio is a good investor for covered calls. Because call options actually reduce the volatility in the portfolio, and it makes your stock portfolio more conservative than it otherwise would be. Higher income, a little more downside protection. So it makes sense for anyone who is interested in equities, really.

Then there is another class of investor. We have some clients who have just been searching for income and they may have otherwise gone to high-yield bonds, and instead they're looking at a covered-call portfolio. The primary reason there is a covered-call portfolio can yield more than high-yield bonds.

And a key distinction: the underlying portfolio is actually higher quality. So you've got AAA, AA companies that you own in the stocks, but they're very high-quality credits, whereas obviously the high-yield bonds tend to be junk credits.

I know during periods of low volatility in the stock markets, option premium tends to go down. We've had pretty low volatility here recently. Is it still a good time to sell covered calls, even though the premiums that you're getting may not be as much?

You know, this market run has been pretty fierce. You're right, volatility is way down. What we do in this type of environment is our stocks inherently through our process become more and more fully valued. We tend to write our calls a little closer to the money and that will maintain a higher call premium and some more protection if the market does decide to take a breather.

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