Covered calls can be an excellent way to generate monthly cash flow while reducing your risk investing in the stock market. While covered calls have been available to individual investors for a long time, covered call – or buy-write – funds have become increasingly popular over the past decade. These funds enable investors to generate an income with covered calls without having to manage their own portfolios – but the convenience comes at a cost.
Let’s take a look at how covered call funds work, some of their benefits and drawbacks, and whether you might be better off taking a do-it-yourself approach.
What Are Covered Call Funds?
Covered call – or buy-write – funds sell call options, collect premiums, and distribute the income to shareholders. These funds are often structured as closed-end funds (CEFs) or exchange-traded funds (ETFs) that hold a portfolio of common stocks, with the goal of exceeding the total return on the S&P 500 index, and sell S&P 500 call options on a continual basis on substantially the full value of its holdings to generate an income over time.
The funds must maintain a less than 70 percent overlap between their stock portfolios and the S&P 500 on an ongoing basis to avoid the so-called “straddle rules” under federal income tax law. At the same time, most funds target at least 80 percent of their value to be subject to written index call options, which maximizes the amount of income generation from writing covered call options. In short, they use relatively complicated strategies.
Benefits and Drawbacks
Covered call funds have the same advantages of writing covered call options, but investors don’t have to manage their own portfolio. The funds send a regular statement that includes the tax status of each distribution that you can simply forward to your accountant. In addition, the funds employ an entire staff of analysts that work diligently to build portfolios that maximize long-term risk-adjusted returns and option income over time.
Of course, these advantages come at a cost. The most popular buy-write ETFs have expense ratios of 0.75 percent, which is higher than the S&P 500 index’s most popular ETF that charges just 0.09 percent. Similarly, the most popular buy-write CEF has a total expense ratio of 1.12 percent, which is significantly higher than broad market index funds. Worse, investors have no flexibility when it comes to managing the underlying stock portfolio.
Investors should also watch out for “return of capital” distributions. Many covered call funds establish a regular distribution – say, five percent – that is paid out on a regular basis. If the fund earns a five percent yield, it simply returns this yield to its shareholders via a distribution. The problem is when the fund doesn’t earn enough yield and instead returns principle to shareholders – in this case, you’re just paying a fee to get your money back!
Should You Do It Yourself?
Covered calls are simple, low-risk strategies that let investors generate an income from an equity portfolio. That said, there are a lot of factors to consider when implementing the strategy and mistakes can be costly. What stocks are best suited for covered calls? What strike price and expiration should be used? How much money should be allocated to any individual position? What do you do when the stock rises or falls in price?
Investors should ask themselves several questions before taking a do-it-yourself approach:
- Are you comfortable managing your own portfolio?
- Do you understand how stock options work?
- Do you have experience trading stock options?
- Do you understand the tax implications of options?
- Do you have the time to commit to portfolio management?
- Does your broker or account type permit these strategies?
Even with an understanding of how covered calls work, they can be extremely risky without the right strategy in place. Covered calls effectively limit a stock’s upside potential since the call can be exercised, while the investor is on the hook for all potential losses of the underlying stock. Covered call premiums can generate an attractive “virtual dividend”, but buying the wrong stocks during a bull market can prove a costly mistake in terms of opportunity cost.
There are also important tax implications when it comes to options trading. For example, investors must track every covered call trade that they make and report the results on IRS Form 8949. Fortunately, many brokerages handle these kinds of tax reporting. Option premium is generally short-term capital gains taxed at your normal income rate. However, you can trade covered calls in a tax-deferred IRA or Roth to avoid the tax complications.
Despite these potential pitfalls, managing your own covered call portfolio comes with a host of benefits. The lack of fees could save you tens of thousands of dollars over the years. At the same time, you have the flexibility of building your own long equity portfolio that may have different characteristics depending on market conditions. These benefits could significantly improve your long-term risk-adjusted returns and make the effort worthwhile.
Snider Advisors aims to help individual investors use covered call strategies without the drawbacks of covered call funds. Over the past decade, the company has refined its strategy and created a rules-based approach to investing in covered calls. These rules help answer the tough questions and ensure that investors benefit from predictable results. These rules are offered either as a course or through a managed portfolio with modest fees.
The Bottom Line
Covered calls are a great way to generate monthly cash flow with less risk. While covered calls have existed for a long time, covered call funds have become increasingly popular over the past decade. These funds provide a convenient way to generate income without the complexity of managing your own portfolio, but there is a relatively high management fee involved and you don’t have control over the portfolio.
You should carefully weigh these benefits and drawbacks before deciding whether to invest in a covered call fund or manage your own portfolio. If you decide to manage your own portfolio, Snider Advisors provides a turnkey strategy that can be used to generate monthly cash flow and avoid many of the common pitfalls that do-it-yourself investors may face.