Covered Call Strategy

May 13, 2024

Ensuring a Secure Retirement Income

High-risk strategies are appropriate in specific situations, such as the final moments of the Superbowl, deciding to elope in your 20s, or when you believe the poker pot is easily attainable. Tongue firmly in cheek, of course, but these situations could be worth it because the potential rewards are significant, or there's ample time to bounce back if things don't go as planned. From an investment perspective, it's like going all-in on tech growth stocks.

However, for individuals who are approaching or have already entered retirement, it’s crucial to be cautious and make wise decisions for your financial future. Moreover, for those who have accumulated significant wealth, at this stage, you’ve achieved great success in life and positioned yourself for the retirement you’ve always desired. Why take unnecessary chances? Instead, consider focusing on increasing the protection and diversification in your portfolio. This will help ensure a steady monthly income that can keep up with the rising cost of living.  Here's where covered call strategies come into the picture.

What Is a Call Option?

A call option is a type of derivative that grants the buyer the right, without any obligation, to purchase a stock at a specific price (strike price) within a predetermined timeframe (expiration date).  What could possibly be the motivation behind such a decision?

The purchaser of a call option aims to capitalize on potential stock price gains while minimizing the risk of losses in case the stock value declines.  Whereas the seller of the call option receives a payment and is obligated to sell the stock to the holder of the call option if it’s exercised.  The seller of a call option would have a pessimistic outlook on the price of the underlying stock and aims to generate some profit while still holding the stock. Basically, the buyer has paid for more flexibility while the seller has been compensated for less flexibility.

A covered call ETF or mutual fund strategy involves a manager selling call options on the stocks held in the portfolio to generate income for the investors. Essentially, selling calls (called writing calls in the option world) involves receiving immediate income in return for forfeiting potential future price increases. One important aspect of the strategy is the balance between immediate earnings and a restricted potential for growth. As the allocation of the portfolio dedicated to writing calls increases, the level of exposure to market price growth decreases. Income-oriented strategies will permit the allocation of up to 100% of the portfolio, whereas equity growth strategies will restrict exposure to a maximum rate, say 33%.

Additionally, there is a potential tax benefit since the income obtained from writing calls is classified as capital gains and receives favourable tax treatment if you plan to keep these funds outside of an RRSP or TFSA.  Fortunately, Q Wealth has the capability to execute this strategy on your behalf, alleviating the need for you to undertake it independently.

How Does it Work?

There are two simple examples that illustrate the basics of this strategy.

1. Selling a Put option to acquire a desired position at a more favourable entry price.

For instance, suppose you want to purchase Apple. The current trading price is $100, however, you’re willing to purchase it at $90. If the price of this position drops to or below this level, you will profit from the position. If it does not meet your criteria for good value at its current position, then you should not proceed. Importantly, in both possible scenarios, you retain the monthly premium income earned from selling the Put option. A win-win.

2. Selling a Call option beyond the desired exit point.

Congratulations on your purchase of Apple at $90. Now, you decide that if it moves back up to $100, you will sell and crystalize the gains. Although this would cap the upside at $10, it effectively boosts the returns beyond that target exit position because of the monthly premiums that are generated from selling the call option.  Importantly, this is achieved without increasing the level of risk.

This is the essential foundation of what, in the hands of a skilled professional, can be a powerful strategy to not only generate consistent monthly income, but also safeguard your retirement savings. Q Wealth adds layers of sophistication to this strategy – speak to us to find out more.

Why Now?

Understanding the strategy is crucial as the value of writing calls tends to increase during periods of volatility.  As we move forward into the rest of 2024, there is a sense of political uncertainty due to the ongoing US election and the conflicts in Ukraine and Gaza. Monetary policy uncertainty is a key concern for central banks as they grapple with the challenge of combating inflation and making decisions about potential interest rate cuts.  Why not take advantage of market volatility and turn it into a profitable opportunity?

Where Does the Strategy Fit In?

Contact the team at WealthLife Capital to facilitate your connection with your Q Wealth Portfolio Manager, Fabien Ouellette.  He can help you determine if it would be beneficial for you to consider this as part of your income allocation. If you already have investments in bonds, utilities, and REITs, incorporating this strategy into your portfolio can offer you higher yield, lower volatility, and conservative growth. By generating income even during market downturns, losses can be minimized, and volatility can be reduced. The conservative growth is achieved through a combination of income and capturing some market upside.  

Avoid using covered call ETFs or funds with the intention of surpassing the performance of the underlying market. This fails to recognize the actual worth of monthly earnings, which has the capacity to surpass the inflation rate, provide income diversification, and take advantage of market volatility. Ensure the safety and stability of your retirement funds and avoid taking unnecessary risks with them.

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