Wei Woo from Capital Research has been doing presentations here at our centre for over 7 years. Each month, he provides us with guest blog posts to educate us on a variety of financial topics. This month, he tells us all about Covered Calls. Make sure to watch our WSAC calendar to see when Wei will be in the centre doing his Toonie Talk presentations…we promise you won’t be disappointed.
COVERED CALL STRATEGIES
With High-Interest Savings accounts now paying 5.3 %, about the same as a 1-year GIC, retired investors are always asking what is the market risk compensation for still being in the markets , especially if the purpose of your investments is to provide retirement income.
Enter cover call strategies. A covered call dividend strategy for enhanced income in ETF or mutual fund format is a specific type of fund that employs a covered options strategy to generate income for investors while holding a diversified portfolio of dividend-paying stocks. A typical Covered Cal strategy pays 7 to 10 % of investment income, with an average around 8 % ( before investment management fees from the Financial or Investment Advisor) at the time of writing. Some pay higher, but with less potential capital gains appreciation. Here’s a simplified explanation of how it works:
Portfolio of Dividend-Paying Stocks:
The ETF is made up of a basket of dividend-paying stocks. These are typically large-cap, blue-chip companies with a history of paying dividends to their shareholders. The goal is to provide investors with exposure to these dividend stocks.
Covered Options Strategy:
The ETF or mutual fund manager, or an automated algorithm, sells options on some or all of the stocks within the portfolio. This is done to generate additional income for the ETF. Each call option sold is typically “covered” because the fund already holds the underlying stocks.
Call Option Premiums:
When the fund sells these call options, it collects premiums from the buyers of those options. These premiums represent immediate income for the fund. This additional income is often distributed to investors in the form of dividends.
Obligation to Sell:
By selling the call options, the ETF assumes the obligation to sell the underlying stocks if the option buyers decide to exercise their right to buy the stocks at the specified strike prices. This means that the fund may have to sell some of its underlying holdings at the strike price if the stock prices rise above that level.
In addition to the income generated from selling call options, the fund also earns income from the dividend payments made by the stocks in its portfolio. These dividends are typically distributed to investors on a regular basis, such as quarterly or annually.
The income generated from both the call option premiums and the dividends is usually distributed to the investors in the ETF. Investors can receive these distributions as cash or have the option to reinvest them to purchase more shares of the ETF.
Risk and Return:
While covered call dividend ETFs provide income, they may limit potential gains because they cap the upside potential of the stocks in the portfolio. If the stock prices rise significantly above the strike prices of the call options, the ETF may miss out on some of those gains. However, this strategy can provide a level of downside protection in volatile markets.
In summary, covered call dividend ETFs aim to generate income for investors by holding a diversified portfolio of dividend-paying stocks and selling call options on those stocks to collect premiums. The income from call option premiums, along with dividends from the underlying stocks, is distributed to investors. This strategy seeks to provide a balance between income generation and potential capital appreciation while managing risk. Investors should carefully consider their investment goals and risk tolerance before investing in such investment strategies.