The Fed’s efforts to keep interest rates at all-time lows for an indefinite time period have resulted in a universal search for yield among US investment managers, who have bid up the prices for almost every type of fixed income vehicle and dividend-paying stock. Not surprisingly, the enormous demand for yield has pushed a number of instruments such as municipals, US Treasury bonds, and low-grade corporate bonds to frothy levels that are being discussed now in the context of bubbles. Not only are yields incredibly low on these instruments but investing in them is essentially like playing a game of musical chairs with interest rates. When the music stops and rates begin climbing again (just a matter of time), their values are likely to decline, perhaps substantially.
There is an alternative way to generate income that is available to equity investors through option writing, and many institutional investors have utilized the strategy ever since listed options premiered in the 1970s. There are four advantages of options writing to investors seeking income or yield on their assets:
1.Option income can be much greater than dividend income
2. Option income is not particularly sensitive to interest rates
3. Option income may be derived weekly, monthly, or in any time interval desired from available option expirations
4. Option writing strategies are highly flexible and can easily be implemented or closed at will
Perhaps most importantly, another advantage of options writing is that it does not add to the risk of your existing stock position. In fact, it reduces the risk by the amount you take in from the option sale. What you do experience is a limit to your upside potential in your stock position while you maintain the covered call option. You can potentially lose money in the option, but only if the stock goes up and, if that happens, you will always gain more in the stock position than you lose on the option.
From an income perspective, option writing offers the potential of incremental income on any equity or ETF that has listed options available – even many that already pay a dividend as well. To illustrate, take a stock like Chevron Texaco (CVX). CVX sells at around 108.60 now and pays a dividend of $.90 per quarter, or about 3.3% annually. A March 115 call option on CVX currently sells for .95 and the March expiration is 80 days from now. So, if you owned CVX, you would already get $.90 per share each quarter from the company and by selling a call option for March, you could receive another $.95 for just less than a full calendar quarter from now. In essence, by writing this call, you will have essentially doubled the dividend return to nearly 7% annually (assuming that you repeated the process for the next 12 months). Your tradeoff for this incremental income is that you could potentially end up selling your CVX stock at 115 in March if it is selling higher than that at the time (though this can be avoided by closing your option position prior to expiration.) If that happens, you would realize a healthy gain from the current price in addition to what you receive right now from selling the option.
The CVX example is just one example of how call writing works. There are numerous other options on CVX that one could write instead, and of course numerous other stocks as well. The call writer has a wide variety of ways to implement the strategy and a great deal of flexibility in managing the strategy on an ongoing basis. There are several considerations that will inevitably come up – i.e. which calls to write, if any; whether to close the option position if the stock is climbing; and whether you are willing to lose the stock at the strike price, should that become a likely event. For these reasons, investors should study the strategy first to know what to expect. Sources are available on the Internet, such as www.OptionsEducation.org, and there are books on the subject, such as my own (Options for Volatile Markets, Bloomberg Press, 2011). For a small investment in your time to learn the strategy, there could be much to reap in future potential income. In addition, the Cabot Option Trader service provides covered call writing recommendations on a regular basis. You can try a risk-free trial subscription to the Cabot Options Trader here.