Covered calls for additional retirement income?
d-October expiration date were priced at nearly $2.80. Thus, a client holding 100 shares of Apple stock—a $9,600 value—could have sold (“written,” in options parlance) an option to buy the shares and pocketed a premium of almost $2,800, for an immediate return of about 3%. If that could be repeated for a string of two-month options, the annualized return from selling these so-called covered calls would approach 18%.
Does implementing such a covered call strategy make sense as a way to provide some income for retired clients?
“Absolutely,” says Nick Defenthaler, a planner at the Southfield, Michigan-based Center for Financial Planning, “but it’s important to point out that although writing covered calls for income is certainly one of the most conservative option strategies, it still contains risk. The premiums received are guaranteed upon writing the call but the underlying stock could plummet and lose substantial value during the contract period.”
Defenthaler favors writing calls on a stock that has appreciated in value and the client is willing to sell. “Why not write some options for additional income?” he asks. “If the stock gets called away, profit was still realized and income was also generated. The client, however, must be aware of and comfortable with the possibility of the underlying stock losing value during the option’s contract period.”
As an example, Defenthaler tells of a client who had a large unrealized gain in Ford stock. “The stock was then trading at about $10.50 a share and the client was happy with his profit, ready to lock in his gains,” he recalls. “At my suggestion, he wrote a call with $11 as the strike price, with expiration of the option one month away. The stock closed at about $10.90 on the expiration date so his shares did not get called away during the first contract period. Then he repeated the same strategy for the next month. Eventually, the shares were called away at $11 a share and his total return was increased because of the premium income he received – that would not have occurred if he had hit the sell button at $11 a share as a simple market order.”
Defenthaler notes that writing covered calls generates risks as well as immediate cash flow. The Apple shares now trading at $96 could fall during the call option’s two-month holding period: perhaps not all the way to the $71 level of earlier this year but by more than the $2.80 gain from writing the call.
Moreover, agreeing to sell the shares at the $100 option strike price relinquishes the prospect of even higher returns, if Apple stock soon trades at $105 or even $110. Nevertheless, clients who understand the various tradeoffs may appreciate the added income that writing covered calls can add to a retirement portfolio.
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.