Why Income Investors Shouldn’t Ignore Covered Calls

Jesse Anderson

Published on June 5, 2023

Options may not be the first thing that comes to mind when you think of income investors, but covered calls can help boost your portfolio’s income above and beyond dividends and interest.

For example, the Global X S&P 500 Covered Call ETF (XYLD) has had a 13% average annualized return over the past three years with a 12.85% trailing 12-month yield paid out monthly. That’s better than most dividend funds over the same time frame.

In this article, you’ll learn how covered calls generate income and why you should consider them for your portfolio.

What Are Covered Calls?

Many investors associate options trading with high risk. And, with its unique terminology and concepts, options trading can seem intimidating at first. However, covered calls are one of the more straightforward and conservative options strategies to learn. They’re even permitted in most IRAs, and a few 401(k) plans with approval!

Covered calls are an options trading strategy that involves selling call options against a long stock position. When you sell a call option, you receive a premium (income) upfront, which you keep regardless of whether the option buyer exercises the option. Meanwhile, the buyer has the right to buy your stock at a specific price for a period of time.

Generally, covered calls work best when you have a neutral to slightly bullish sentiment on an underlying stock. And most investors sell options with a strike price that’s at-the-money or slightly out-of-the-money. The goal is to have the option expire worthlessly and keep the premium while avoiding a scenario where the underlying stock decreases in value.

Benefits for Income Investors

Many income investors hold bonds or dividend-paying stocks to generate predictable income. While these are excellent choices, covered calls offer unique attributes complementing a traditional fixed-income portfolio.

The most significant benefits include:

• Enhanced Income: Covered calls generate extra income from a long stock position. For example, if you write covered calls on a dividend stock, you will receive the dividend and premium income, boosting your overall portfolio income.
• Less Volatility: The premiums you receive from covered calls can buffer against potential losses on your stock positions, effectively lowering your cost basis. As a result, they can make your portfolio less susceptible to market fluctuations.
• More Diversification: Many income investors limit their focus to fixed-income or dividend stocks. But, using covered calls, you can invest in a diverse mix of stocks and still generate an attractive income – including growth stocks that don’t pay dividends.

How to Screen for Opportunities

Investing in covered calls is a bit more nuanced than bond funds or dividend stocks. In addition to choosing an underlying stock that’s not likely to see a significant decline, you must select the price and expiration date for the call option you wish to sell. The best options offer a combination of attractive income and a low exercise probability.

Some important metrics to consider include:

• If-Called Return: The if-called return is how much you would earn if the option buyer exercises the option and calls the stock. Other than the underlying stock falling, this is the worst-case scenario.
• Downside Protection: Downside protection is how much underlying stock downside the covered call’s premium offsets. It’s a good way to assess how much protection you’re receiving in income per dollar invested.
• Stock Events: Earnings dates, ex-dividend dates, and other events can lead to higher volatility, which increases the likelihood of the buyer exercising their option.

Option screeners like OptionDash are the best way to identify covered call opportunities. For example, you can screen for stocks and associated covered call opportunities and sort them by if-called return. Then, you can dig into each opportunity to assess the underlying stock’s fundamental risks and potential for volatility.

In addition to these basic features, OptionDash makes it easy to screen for stocks and associated covered call opportunities by technical trend scores, fundamental factors, market capitalization, or other attributes. You can even access analyst estimates and valuation estimates based on discounted cash flow analysis and other methods.

Getting Started

The Snider Investment Method offers one of the easiest ways to get started with covered calls if you want more in-depth guidance. The free e-course will teach you how to screen for opportunities, tips for managing positions over time, and much more. For example, you’ll learn optimal strike prices, expirations, and how to handle when a stock’s price declines. 

Snider Advisors also offers the Lattco platform to help manage trades automatically. The platform automatically bundles suggestions that meet the Snider Method criteria while a comprehensive wizard takes you through every trade for all your positions. As a result, it’s much easier to know precisely how to react to any situation that may arise.

If you want to capitalize on covered calls without day-to-day portfolio management, Snider Advisors also offers asset management services. That way, you can leave the heavy lifting to experts and focus on managing other parts of your portfolio.

The Bottom Line

Many income investors stick to fixed-income or dividend stocks to generate portfolio income, but covered calls may be worth considering to diversify a portfolio. Rather than concentrating risk and limiting income to specific opportunities, you can write covered calls on a wide range of stocks and fine-tune your income potential and risk.

Take our free e-course and sign up for OptionDash to get started today!