Many retirees draw down their portfolios to finance their retirement, but generating income can help stretch your savings much longer. While dividend stocks and bonds are popular income investments, covered calls can provide an extra boost (and some downside protection). As a result, they may be a worthwhile addition to your retirement plan.
In this article, we’ll examine how covered calls work, look at a few examples of using them to generate income, and discuss other considerations for retirement investors.
How Covered Calls Work
Covered calls are a popular options trading strategy where an investor holds a long stock position and simultaneously sells a call option against it.
By selling the call option, the investor earns a premium from the option buyer, who pays for the right to purchase the stock at a predetermined price (strike price) before an expiration date.
There are two possible outcomes:
- The underlying stock price doesn’t exceed the strike price, the option expires worthless, and the investor keeps the premium.
- The underlying stock price exceeds the strike price, the buyer exercises the option, and the investor has to sell the stock or buy back the option.
You can use covered calls to generate income, hedge against downside risk, enhance returns, or all of the above. That said, many investors use covered calls as a way to boost their portfolio income during retirement.
How They Generate Income
Suppose you hold 100 shares of ABC Corp., and currently, the stock trades at $50 per share. To generate extra income, you sell a call option with a strike price of $55 that expires in one month for a premium of $1 per share. As a result, you pocket an immediate $100 in premium income ($1 x 100 shares) that you get to keep regardless of what happens next.
There are a few possible outcomes:
- The stock price stays at $50 per share, and you pocket the $100 in premium income. In this case, you’ve generated extra income you wouldn’t have received otherwise.
- The stock price falls to $45 per share, but you only lose $4 because of the $1 premium. In this case, you lost less money than you would have otherwise.
- The stock price rises to $60 per share, and you must sell the stock (or take a loss on the option by purchasing it for more than the premium you originally received) for $55, resulting in a $4 opportunity cost ($5 – $1 premium).
By holding a diversified portfolio of covered calls, you can mitigate the risk of any single stock going down and generate consistent income. You can also continue collecting any dividends your underlying stocks pay unless the option buyer exercises their option prior to the ex-dividend date..
Pros & Cons of Covered Calls
Covered calls are a very popular strategy to boost retirement income, but it’s worth carefully considering the pros and cons before using them.
Pros
- Income – Covered calls can provide regular income to supplement retirement income and help cover living expenses. You can even write covered calls on dividend stocks.
- Low Risk – Selling call options can help minimize downside risk by creating a buffer if the stock price declines. And covered calls themselves are a low-risk option strategy.
- Capital Appreciation – You can still realize capital appreciation up to the strike price when using covered calls. As a result, you can benefit from both income and capital gains.
Cons
- Limited Upside – Covered calls limit your upside potential beyond the strike price. If a stock moves sharply higher, you could miss the rally and experience high opportunity costs, which could be emotionally taxing and result in missing return targets.
- Market Risk – Covered calls can help buffer a decline in an underlying stock, but it doesn’t offer any significant protection. If a stock falls sharply lower, you could experience significant losses. So, it’s important to select high-quality stocks.
- Tax Implications – The IRS typically taxes covered calls income as short-term capital gains. Moreover, you could experience short-term capital gains if an option buyer exercises your covered call and you have to sell a stock you’ve held for less than one year. However, this doesn’t apply in tax-advantaged accounts (more on that next).
Using Covered Calls in IRAs
Individual retirement accounts (IRAs) are investment accounts designed to help you save for retirement. Traditional IRAs allow you to make contributions on a pre-tax basis, while Roth IRAs permit contributions on an after-tax basis. Either way, they can help you reduce your taxes compared to a traditional brokerage account.
Many individual retirement accounts (IRAs) permit covered calls, but you may have to check with your custodian or brokerage to be sure. By trading covered calls in an IRA, the income you generate may not be taxed immediately (traditional IRA) or may compound over time tax-free (Roth IRA), helping you save more over time.
Keep in mind, old company-sponsored retirement plans (401(k), 403(b), etc) can be rolled into an IRA. Rolling these funds into an IRA makes a lot of sense when you are no longer employed with the sponsoring firm. First, you have a lot more control when the funds move into an IRA in your name. It also helps ensure all your assets are working together as one toward your ultimate investment objectives. With the addition of covered calls in your IRA, you can maximize the portfolio paycheck your funds are capable of producing.
Strategies to Maximize Income
Covered calls are low-risk, but that doesn’t mean they’re easy. For example, when selecting opportunities, you need to pay close attention to the underlying stock and market conditions. And managing a covered call portfolio can be time-consuming, especially when the underlying stock moves sharply lower or higher.
OptionDash’s covered call screener can help you find the best income-producing opportunities by looking at annualized returns, if-called returns, and other metrics. Source: OptionDash
OptionDash makes it easy to find the best income-producing opportunities, with its easy access to return projections and proprietary scoring systems. For example, you can screen opportunities by annualized return and look for stocks with an acceptable fundamental profile and downside protection to limit risk and enhance potential risk-adjusted returns.
Some tips to remember include:
- Asset Selection – You can maximize covered call income by selecting stocks with higher implied volatility. But be careful; these stocks may also have a higher risk of being called away if the price temporarily exceeds the strike price.
- Strike Price – Most covered call investors choose strike prices slightly above the current stock price to reduce call risk while still earning a reasonable premium. However, options that are more in the money have higher premiums.
- Expiration Date – Longer-term options tend to have high premiums because there’s more time for the stock price to reach the strike price. But, of course, there’s also more of a risk of the option being called away over time.
- Diversification – Diversification is essential for any portfolio, and covered calls aren’t an exception. When investing in covered calls, diversify across multiple stocks and sectors to avoid stock-specific risks.
If you’re new to covered calls, Snider Advisors provides a free e-course to help you get started. The Snider Investment Method covers must-know topics like screening for the right stocks, choosing the optimal strike price and expiration date, and managing positions over time. And you can even use Snider Advisor’s custom platform, Lattco, to execute your trades.
The Bottom Line
Covered calls are a popular way to generate retirement income, but there are a few caveats to remember. By keeping these tips in mind, you can maximize your income potential with covered calls while mitigating risk.
If you’re looking to generate income with covered calls, Snider Advisors offers a free e-course to help you get started. Our online or live workshops will teach you a complete portfolio management strategy, while our proprietary stock analysis and automated trading software, Lattco, will guide you through the trading process each month. Get started today!
