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Any investor with the slightest connection to reality should — at the very least - entertain the notion that equity markets could be in for a prolonged slump. For a less-than-rosy perspective look at a price chart of the S&P 500 and imagine being an investor from 1965 to 1975 — a decade when the average stock moved sideways to down slightly.
For some reason we humans are inclined to think equity markets will always go up, which simply isn't the case. Bonds and dividend stocks are the most popular alternatives to generate returns through income but low historic interest rates have brought yields down.
Making money in this environment means thinking differently. Writing covered call options is one strategy that can generate yield income, a premium, potential for capital gains, and limit risk.
To be covered means to own the underlying equity and that's an important stipulation in limiting risk. The opposite is a naked call option, meaning money is borrowed to write the call option.
When writing a covered call option you give the buyer the right, but not the obligation, to purchase an agreed quantity of a security you own at a specified time in the future for a specified price. That price is referred to in the options industry as a 'strike price.'
In return, the buyer pays the writer a premium in the hope the price of the security will rise above the strike price by the specified time. That gives him the right to buy the higher priced stock at the lower price. When the price of the underlying security surpasses the strike price, the option is said to be 'in the money.'
As the writer your first payoff is the premium. The second payoff is the dividend yield from the securities under your ownership.
In addition, you could reap capital gains on the security if it rises above your original purchase price buy remains below the strike price (in which case the buyer would not exercise the option). If the security rises above the strike price and the buyer exercises the option, the seller still retains the premium and yield.
There is a downside to writing covered calls. If the security rallies well above the strike price you are not entitled to those gains. In accepting the premium the writer sells the bulk of the risk as well as the reward.
If the equity market climate is similar to the period between 1965 and 1975 and the security retains its value without rising above the strike price - and the buyer does not exercise the option - the writer takes his security, premium and yield and goes home. From there the covered writer can keep writing calls indefinitely until the option is exercised by the buyer.
If the stock falls below the purchase price the reward for the seller is limited risk. Any capital loss could be offset by gains from the premium and yield. The seller also keeps the security, so any loss is merely a paper-loss and the potential remains for the security to rise in the future.
The call writer also has the ability to repurchase the call option before it is exercised by the buyer and write another call option for a later date. Calls are constantly being traded and priced on the options market in volumes that exceed even stocks. Repurchasing the call option permits you to maintain ownership of the security while collecting additional cash through premiums.
The repurchase price, however, is established by the market and could be high if the stock is rallying. Strike prices and premiums are also set by the market and are determined by demand. Institutional investors often employ complicated options strategies to offset risk in other areas of their portfolios.
Studies have shown that even professional money managers, not to mention individual investors, can never consistently outperform the market average. By writing covered calls your chances of beating the market are far greater while risk is reduced.
The options market is a very tricky game. To find if writing covered calls is the right option for you it's best to speak with a financial advisor, who can help match the right equity to the right option.
Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.