Retirees who need income today may find it very challenging to produce their desired cash flow. Interest rates are well below historical norms. As a result, many retirees are stretching for yield and buying high-yield bonds and bond funds and dividend paying stocks.
The risk-reward ratio in the high-yield bond market isn’t too good right now, and investors may not be getting compensated for the risks they are taking. Dividend-paying stocks can also be a good income alternative depending on your individual risk tolerance.
A steady income stream can be obtained by selling covered calls against dividend-paying stocks or funds. Remember, options are not suitable for all investors.
The main drawback to selling covered calls is that you are limiting the upside potential of your stock by giving someone else the right to call it from you at the strike price on or before the expiration date. However, if cash flow is your primary objective, covered call writing might be a strategy worth considering.
Volatility is an important concept for investors to understand. Two different stocks may have very similar returns, but have completely different volatility characteristics. High portfolio volatility can make retirees nervous.
Two different types of volatility that covered call writers need to understand are historical volatility and implied volatility. The historical or statistical volatility is a measure of how volatile the stock has been, and it can be measured over different time frames.
The implied volatility is derived from the price of the option contract and will vary with different strike prices and expiration dates. High implied volatility indicates that the market is anticipating large price movement in the stock.
There are many large cap stocks that have dividend yields in the 3 percent area; when combined with call writing it is very realistic to get static annualized returns of 4 percent or so from the call income, which adds up to a static return of about 7 percent. You’ll also be allowing the stock some room to move up in price, but will be limiting the potential price appreciation to about 10 percent annually.
Covered calls don’t have to be written on individual stocks; they can also be written on ETFs if you have a need for diversification. They can be written on broad based index funds, sector funds and bond funds. Stick with the large cap issues which are the most liquid, so you get the best executions.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information on his money management service can be found at his blog at www.sellacalloption.com or by calling 775-657-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.