Stock rally, high rates have advisors rethinking covered call strategies

Hedging equities with option income loses some luster, but still works for certain clients.

With the stock market a few weeks back into bull market territory, financial advisors might be rethinking their exposure to covered call strategies that tend to gain appeal during flatter markets when interest rates are lower.

But for certain types of clients, covered call strategies that can soup up the income of stock positions they already like might be just the ticket in a market environment that some analysts believe could be running out of steam.

“There are times to use covered call strategies and times when they don’t work well; I am currently using them selectively,” said Scott Bishop, managing director at Presidio Wealth Partners.

Bishop acknowledges the potential downside of selling call options on stocks that can be called away by the option holders, which can trigger brutal capital gains hits if those stocks have lots of built-in gains.

Those are some of the risks associated with a covered call strategy in a bull market, but that doesn’t mean there isn’t also a case for covered calls.

“The best time to use covered call strategies is when you want extra income in sideways or slightly bearish markets,” Bishop said.

Specifically, he likes covered calls for stocks that have some implied volatility. “You can many times get some good income off of the covered calls option writing,” Bishop said. “This strategy works well to get you extra income above and beyond any dividends.”

Covered call strategies started reappearing on advisors’ radar screens a few years ago when interest rates were near zero and the stock market was less robust, making the income from option sales look like a win-win for investors.

The appeal of the strategy was most dramatically illustrated by the JPMorgan Equity Premium Income ETF (JEPI), which enjoyed a perfectly timed launch three years ago and ballooned to nearly $28 billion.

As an income play, JEPI has a 12-month yield of 10.92% with a year-to-date gain of 5.3%.

Stacked against a 15.8% gain this year by the S&P 500 Index, JEPI looks less impressive. But remember, price performance is only part of the reason to invest in a covered call fund.

Martin Smith, president of Wealthcare Financial Group, has been using Global X Russell 2000 Covered Call ETF (RYLD), which has a 12.66% 12-month yield and is up 2.5% this year.

“I added it to my model portfolio because I built a defensive allocation and it has a nice yield,” he said.

Smith said the fund, which was down 13% last year, can be volatile, which is why he caps the allocation to 5%. “It is an income play, but also provides some alpha potential on the upside,” he said.

It’s a similar story for Amy Hubble, principal investment advisor at Radix Financial.

“For our clients invested in our individual core equity strategy, we are using covered calls to increase income to the portfolio,” Hubble said. “Options trading is a zero-sum game, meaning one side wins and the other loses, but selling covered calls on individual equities you already own allows you to collect the option premium from the long buyer and minimize your risk.”

Paul Schatz, president of Heritage Capital, is currently taking a neutral position when it comes to covered call strategies, which is more reflective of his bullish outlook for stocks than a rub on the strategy.

“In strong uptrends for equities, investors leave a lot on the table for that option income,” Schatz said. “In strong downtrends, the income adds a little buffer to the losses, but maybe not enough to satisfy the investor. I would rather be more opportunistic. I think I can add more value than just using a blanket defensive strategy.”

Noah Hamman, chief executive of AdvisorShares, can appreciate Schatz’s perspective that the current market doesn’t exactly roll out the red carpet for covered call strategies. Hamman describes the AdvisorShares Star Global Buy-Write ETF (VEGA) as “a little bit of an equity market hedge.”

“You’ll still get some equity movement and a little income to offset the downside,” he said.

Hamman said the Fed’s recent monetary policy has hurt covered call strategies because investors are less interested in income from options when money market funds are yielding 5%.

But if an advisor already likes the equity exposure, he said it’s an easy next step to add some income from the sale of an option on the position. “You take an asset you’re already comfortable with and put it to work and get a little extra income, and all you’re risking is excess upside,” Hamman said. “But since 95% of options never get exercised, you’re basically AirBnb-ing your stock position.”