Buy-Write vs. Covered Call Strategies: What’s Best for Your Portfolio?
Jesse Anderson
Most investors want to maximize portfolio income during their retirement years, but there’s a big trade-off when you swap high-growth stocks for fixed income securities. While bond yields have crept higher since the COVID-19 pandemic, equity market returns continue to roundly outperform bond market returns over the long run.
So, how can you squeeze more income out of a stock portfolio?
Dividend stocks may offer a way to generate income while holding equities, but they’re limited to a small subset of the stock market. On the other hand, equity-listed options offer a way to generate income from a much wider basket of stocks—including high-growth companies.
In this article, we’ll look at two strategies that involve selling call options against a long stock position to generate income—and how to decide on the best option for you.
Understanding the Basics
Buy-write and covered call strategies both involve the same underlying mechanics: Selling a call option against a long stock position to generate premium income.
Here’s how it works: Suppose you own 100 shares of Acme Inc. that trades at $100 per share. You might sell a call option with a strike price of $110 per share and an expiration date one month in the future. This enables the buyer to purchase the stock from you at $110 anytime during the next month. In exchange, you might receive a $1 per share premium.
Now, let’s consider how the next month might play out:
- If the stock rises to $120 per share, you will have to sell the stock for $110 per share, realizing a $10 per share profit plus the $1 per share option premium. But, of course, you would miss out on $10 per share in would-be capital gains.
- If the stock stays at $100 per share, you keep the $1 per share premium as profit.
- If the stock falls to $90 per share, you will lose $9 rather than $10 per share thanks to the $1 per share premium that acts as a buffer.
As you can see, the biggest downside of selling call options is usually the opportunity cost, or the profit you could have earned if you didn’t sell the right to the stock. But, of course, you’re also on the hook for any losses if the stock price moves lower. This trade off may not be worth it for younger investors, but retirees may prefer the extra income!
The terms “buy-write” and “covered call” are often used interchangeably when describing this basic strategy, but there’s an important distinction between the two.
Covered Calls: Ideal for Long-term Investors
Many long-term investors sell call options against stocks they already own.
For example, if you own Acme Inc. as a long-term investment, you might sell call options to generate a premium income above and beyond any dividends. It’s a great way to squeeze a little extra yield out of your existing portfolio if you don’t mind sacrificing some potential upside if the stocks you own were to unexpectedly move higher.
You can also benefit from favorable tax treatment. If you’ve held a stock for longer than one year before selling it, you will pay the lower long-term capital gains tax rate. But, of course, any option income you generate is taxable as ordinary income (like bond interest). The exception is if you trade covered calls in a tax-deferred account like a Roth or IRA, where realized gains and losses aren’t reported on an annual basis.
Buy-Write: Best to Maximize Income & Yield
Other investors are looking to maximize their cash yield and may prefer buy-write strategies.
Rather than generating a bit of yield from existing stocks, these investors seek out stock and option pairs with the most attractive yields and buy them at the same time. They care less about the stock’s underlying fundamentals since they don’t plan to be a long-term holder. Instead, once the option expires, they usually sell the stock and move on to the next opportunity.
The biggest drawback of this approach is it incurs short-term capital gains taxes. In addition to paying ordinary income tax on any premium income, buy-write investors typically owe short-term capital gains when they sell the underlying stock. Depending on their tax bracket, this could become costly from a tax standpoint and eat into profitability and returns.
How to Find the Best Opportunities
Option screeners are the easiest way for buy-write and covered call investors to find opportunities across their portfolios or the broader market.
Covered call investors can leverage tools like optionDash to compare the yields of various option expiration dates for a stock you own. In addition, you can quickly identify when earnings or dividends may jeopardize option strategies. And you can see each option’s downside protection if you’re using covered calls as a hedge of sorts.
optionDash offers one of the best covered call-specific screeners to help you find the best opportunities. Source: optionDash
If you’re a buy-write investor, you can screen the broader markets for the best income opportunities at any given point in time. For example, optionDash makes it easy to sort buy-write opportunities by if-called return while visualizing the technical and fundamental strength of each underlying stock to avoid potential risks.
And best of all, you can get started for free!
Beyond Buy-Write & Covered Calls
Selling call options is just one of many ways to generate income from options. While it’s the easiest strategy for beginners, sophisticated investors often prefer other approaches to generate even more income. But, of course, each strategy comes with its own risk-reward profile, capital requirements, and knowledge to effectively execute.
Some other option income strategies include:
- Cash-secured Puts – Cash-secured puts involve writing put options while maintaining cash collateral on the sidelines. It’s a great option if you want to acquire stock at a lower price but want some yield while you wait.
- Diagonal Spreads – Diagonal spreads are similar to covered calls, but instead of buying the underlying stock, you buy a longer-term call option and write shorter-term call options against it to generate premium income.
- Iron Condors – Iron condors involve a combination of bull put spreads and bear call spreads to create a market-neutral strategy. In range bound markets, it’s a great way to generate income while limiting exposure to downside risk.
Some investors also prefer an “option wheel,” which involves selling cash-secured puts until you’re assigned a stock. Then, you can write covered calls against the stock you’re assigned until it’s called away. After that, the wheel restarts by writing cash-secured puts.
If you’re interested in the option wheel or just cash-secured puts, optionDash provides one of the few screeners on the market targeting these opportunities. With a single click, you can switch between screening for covered call or cash-secured put opportunities based on your market outlook and portfolio requirements.
The Bottom Line
Buy-write and covered call strategies are both excellent ways to generate extra income without resorting to fixed-income securities—but they take two different approaches to the market. Long-term investors may prefer covered calls while short-term traders might leverage buy-write strategies to maximize their yield.
If you’re interested in learning more about covered call strategies, take our free e-courses to learn everything from building an optimal portfolio to selecting the best options.
And, if you’re looking for buy-write opportunities, the optionDash screener can help identify the highest-yielding prospects in the market.
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