With cash equivalents paying next to nothing and popular bond funds yielding around 2%, advisors lack an easy path to meaningful investment income. As a result, some are selling covered calls — an options strategy that lets clients hold a stock for potential profit while making income-producing side bets on its intermediate-term movement.

“We use covered calls as an income solution for our conservative investors,” says Herstle Jones, who heads a planning firm in Medford, Ore. “Trying to generate 5% to 6% per year in income can be difficult for such clients in today’s environment, but we can do this with call proceeds and dividends.”

Yet not all covered calls are low-risk options. “One of our recent covered calls is not suitable for a 65-year-old with a modest tolerance for risk,” says Ronald Heakins, president of OakTree Investment Advisors in Pittsburgh. “This particular transaction works better for clients in their 40s and 50s.”

The covered call that Heakins deemed risky involved Kansas City Southern (KSU), a railroad whose stock had plunged on adverse news. His firm then bought shares at just over $95 early in 2014 and sold calls with a $100 exercise price, to expire this September. The net selling price of the call was about $5.60, or $560 per 100 shares.


If the shares had just treaded water until the option expires, investors would have retained the shares after pocketing the option premium and the quarterly dividends. Heakins calculated the annualized return in this scenario at 11.5%.

That’s one winning strategy. But there are downsides too. With KSU trading around $107 as of early June, the stock may get called away at expiration in a sale for $100. The resulting profit would boost the annualized return to nearly 20%, but selling at $100 in September might not thrill clients if the stock trades then at $110 or higher.

“That’s really not a concern,” Heakins says. “Our clients are well-educated about our strategy ... so they know the maximum return they can expect.”

Meanwhile, the $5.60 option price wouldn’t make up for the paper loss if the stock fell to $85 or $80 a share — although, Heakins says, the client might continue to hold the shares. “We like the industry,” Heakins says, “and we like the company. It continued to make money in 2008 and 2009. If the price had dropped, we wouldn’t have minded owning it, even for a longer term.”

Still, Heakins cautions that KSU’s beta and standard deviation are much greater than the broad market’s numbers, making the company too volatile for very conservative clients.


The classic buy-write strategy involves buying a stock and selling a call on the newly acquired shares. But covered calls can also be used to initiate the sale of an existing holding; some advisors mention using covered calls to reduce holdings of stocks in which clients might be overexposed.

“We use covered calls to reduce concentrated positions for clients nearing or in retirement,” says Mark Cortazzo, senior partner at Macro Consulting Group, a planning firm in Parsippany, N.J. “We have found it to be a successful strategy to mitigate risk.”

Clients with large positions might write covered calls on some of the shares, he says, gradually thinning down to the desired amount.

Selling covered calls can provide a “forced sell discipline,” says Jay Furst, a principal at Forteris Wealth Management in Purchase, N.Y. “For some investors,” he says, “selling can be hard to do.”
Explaining the concept to clients can sometimes be a challenge, Furst says. The best way to lay it out, he has found, is to use examples — if we sell this call on Stock X, this or that or some other return might result, depending on how the stock price moves.


The math involved in selecting covered calls to sell can be difficult. So advisors who don’t want to crunch all the numbers can use one of the dozens of funds that follow buy-write strategies. Results can vary widely, of course.

“If you are interested in a covered-call fund,” says Greg Carlson, a senior fund analyst at Morningstar, “you’ll want a manager who has been through market cycles. The results would indicate how well the manager knows how to use options.”

According to Morningstar, most of the covered-call funds that went through the recent bear and bull markets wound up with decent if unspectacular results. Yet there were outliers — some with double-digit returns and some with losses.

Another option for advisors is to participate in covered calls via separately managed accounts. That’s the approach that Jones has been taking, working with Gradient Investments of Arden Hills, Minn. “Our clients have been very happy with the consistent results of this portfolio,” he says, “coupled with the fact that it has about half of the volatility of the overall stock market.”
Gradient’s covered-call strategy uses ETFs: “We typically hold seven to 10 ETFs, choosing those with a very liquid options market, and sell covered calls on those,” says Wayne Schmidt, Gradient’s chief investment officer. Generally, the ETFs in this portfolio track major market indexes or sector indexes.

Schmidt says he typically will sell out-of-the-money calls — those with an exercise price higher than the current share price — on these ETFs, often with 30-day expirations. “If they expire, we’ll write another call,” he says. “If the call is exercised, we have a profit ... and if we still like the prospects of the ETF, we’ll buy it again and keep writing calls.”

Recent returns have been around half those of the broad stock market, Schmidt says, with lower volatility. Jones says these results meet his goals for this portfolio — creating monthly cash flow, participating in up markets, and protecting in down markets. FP

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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