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There’s a time and a place for high-risk strategies – the last-minute of the Superbowl, eloping in your 20s, when you think the poker pot is there for the taking. Tongue firmly in cheek, of course, but all these situations are worth it because the rewards are high or there’s enough time in your life to recover if it goes wrong. In investing parlance, it’s akin to putting all your money into tech growth stocks.
But for those heading towards or already in retirement, now is not the time to gamble with your future. Besides, for the high-net-worth, by this point you’ve already “won” at life and set yourself up for the retirement you’ve dreamed about. Why risk it? Instead, you need more protection and diversification in your portfolio, with the “bird in hand” of monthly income as cost-of-living increases. This is where covered call strategies come into play.
What is a call option?
A call option is a form of derivative that gives the buyer the right, but not the obligation, to buy a stock at a certain price (strike price) for a set period of time (expiration date). Why would anyone want to do that? The buyer of a call option wants to benefit from the potential price increase of the stock without the downside risk if the stock falls. The seller of the call option receives a payment and has the obligation, not the right, to sell the stock to the holder of the call option if exercised. The seller of a call option would have a flat-to-down price view of the underlying stock and wants to generate some return while they hold it. Essentially the holder has paid for increased flexibility and the seller has been paid for decreased flexibility.
A covered call ETF or mutual fund strategy is where a manager writes calls on the held portfolio of stocks to generate income for the investors. Writing calls effectively provides current income in exchange for giving up on potential future prices increases. A key dynamic of the strategy is the trade-off between current income and limited upside. The higher the portion of the portfolio used to write calls, the less exposure to market price growth. Income oriented strategies will therefore allow up to 100% of the portfolio to be written, while more equity growth strategies will limit exposure up to a cap rate like 33%. The good news is that Q Wealth can carry out this strategy for you, rather than you having to implement this on your own. There is also a potential tax advantage as income generated by writing calls is considered capital gains and has preferential tax treatment if you intend to hold these funds outside of an RRSP or TFSA.
How does it work?
There are two basic examples that explain the fundamentals of this strategy.
1. Selling a Put option to buy a desired position at a more favourable entry price.
For example, say you want to buy Apple. It’s trading at $100 but you’re willing to buy at $90. If this position falls to or below this price you would gain the position. If it doesn’t, and you don’t see good value at the position it’s at, you don’t. Crucially, in both potential outcomes, you get to keep the monthly premium income generated for selling the Put option. A win-win.
2.Selling a Call option above their targeted exit point.
You now own Apple at $90 – congratulations. However, you decide if it moves back up to $100, you will crystalize the gains and exit. While this caps the upside at $10, it effectively enhances the returns over and above the target exit position by generating those extra monthly premiums. Crucially, this is done without taking on more risk.
This is the nuts and bolts of what, in professional hands, can be an effective way to not only generate monthly income but also protect that retirement portfolio nest egg. Q Wealth adds layers of sophistication to this strategy - speak to your advisor to find out more.
Why now?
The key to this strategy is that the value of writing calls goes up in periods of volatility. As we barrel into the rest of 2024, there is political uncertainty with the US election and two wars grinding on in Ukraine and Gaza. We also see monetary policy uncertainty as central banks fight inflation and try to determine when, or if, to cut interest rates. If market volatility is a factor to contend with, why not profit from this backdrop?
Where does the strategy fit?
Reach out to the team at Arca Financial Group to connect you with your Q Wealth Portfolio Manager, to see if it makes sense for you to look at this as part of your income allocation. If you already have exposure to bonds, utilities and REITs, an allocation to this strategy will provide enhanced yield, reduced volatility, and conservative growth. The reduced volatility is achieved by earning income even if markets are down, which mitigates losses. The conservative growth is achieved as a combined result of the income and some market upside capture.
Just don’t use covered call ETFs or funds with the expectation of trying to outperform the underlying market. That view misses the true value of monthly income that has the potential to exceed the inflation rate, offer income diversification, and exploit market volatility. Secure your retirement, don’t gamble with it.