Covered call funds can increase yield and reduce risk

Investing in covered call equity funds can offer many benefits for investors when used as part of an investment portfolio. Covered call funds utilize the technique of investing in a portfolio of stocks while using a derivative option strategy of writing call options against individual securities inside the fund to generate option premiums. Since the fund owns the security that an option is written on, the fund is considered "covered" in the event the security is called away. While this seems like a complicated topic, I'll do my best to explain how these funds can offer a great investment vehicle that, at times, can outperform the stock market, provide cash flow yields that exceed the dividend yield on stocks, and take less overall market risk. The first step to understanding covered call funds is to understand option premiums. Option premiums are the monetary amount that option buyers pay option writers to enter an option contract. Fund managers will write call options against securities they feel are fully valued with the expectation that the option will expire out of the money (or at a price where the option wouldn't be exercised). The amount of premium received for writing the option depends on the exercise price, the duration until the option expires, and volatility levels of the security the option is written on. Premiums received by the fund add an additional income stream that enhances total yield paid out to shareholders. The relation of the exercise price relative to the current stock price will be the main contributor of the amounts of premium value that can be earned by option writers. The option writer will be compensated with a higher premium when issuing a contract with a strike price at or near the current market price since the risk of having the option exercise increases. The wider the relation of current price to strike price of an option contract, the lower the premium that can be earned by the option writer. The length of the option contract is also an important factor toward option premiums. Option contracts can take various lengths of time (typically 1-3 months) but can be longer in duration. The longer the option contract is written for, the higher the time value portion of the premiums will be. Volatility levels of the underlying security will impact option values too. During periods of heightening volatility, options become more valuable, resulting in higher premiums that can be earned by option writers. The buyer of the call option is paying the option premium for the right to buy the underlying security at the predetermined strike price. The buyer is taking a long position, betting that the stock will rise above the strike price over the term of the option. For example, a call option buyer of Apple stock could pay a $4 per share premium with a $100 strike price for an option that expires in 3 months. If the option ends in-the-money, higher than the strike price of $100, the option will be exercised and the option buyer will profit by being able to purchase the stock below market value. However, if the stock ends out of the money, under $100, the fund profits by the amount of the premium and will retain the security. Covered call funds are typically less risky compared to traditional equity funds, depending on the amount of option overlay inside the fund, having the potential to take significantly less market risk. These funds will perform best when markets are in a tight trading range where stocks do not reach their strike price and the fund can continuously write call options without securities being called away. Additionally, the premium received will act to hedge downside risk in the event stocks lose value. Option premiums will offset any initial loss of the stock by the amount of the premium before the fund starts feeling any loss. This downside hedge protection provides covered call funds the ability to reduce market risk. While these funds perform well in flat markets, they may lag during periods when the markets make strong upside moves because the writer of a call option is essentiality capping upside potential on the covered security. If the security rises dramatically above the exercise price, the fund has capped upside return by the strike price plus the premium received. In my Apple example, if the stock reached $108 on a $4 premium, the option would be exercised and the fund would miss out on $8 of price appreciation. However, some of the missed upside is offset by the premium received at the initiation of the option contract but the fund will still miss out on $4 of price appreciation. Furthermore, if the fund wants to maintain the position that was called away, the position would be re-established by the fund at a higher price. This strategy is not very complex but it does have a lot of moving pieces. This is why I believe the average investor should not attempt the strategy themselves because it takes a significant amount of time, resources, and expertise to implement successfully. Investment managers such as BlackRock, Nuveen, and Eaton Vance, among others, offer investments in closed-end funds, mutual funds, and ETFs that provide retail investors easy access to covered call funds. If you feel covered call funds can add value to your investment portfolio, speak with your financial professional to discuss their suitability for your overall investment strategy. ----- James Quackenbush is a Senior Domestic Equity Analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully's Trail, Pittsford. Call 585-586-4680. Published: Mon, Aug 15, 2016