Use this strategy to generate portfolio income from your stocks as markets rise

Published Thu, Jul 27 20232:37 PM EDT

An options strategy that's done just right will let you capture appreciation as stocks rise and generate some portfolio income. Enter covered calls. In this two-pronged strategy, an investor buys a stock and then sells a call option – that is, the right to purchase the asset at a specified or "strike" price by a certain date – to another investor. When these two steps are done simultaneously, it's known as a "buy-write." This way, the premium from the sale of the call option generates income. Further, if the strike price for the call is higher than the current price and the stock rises, the initial investor sells the stock and captures some appreciation. "The reason you'd want to sell covered calls is that you can earn income when the stock is going sideways," said Randy Frederick, managing director of trading and derivatives at the Schwab Center for Financial Research. "At the end of the month, the stock gets called away from you, but you make money on the stock and earn money from the income," he said. "Or the covered call expires worthless, and you keep what you earned from selling it." Here's how to incorporate this strategy into your portfolio. Covered calls and market performance Even with the S & P 500 up 19% year to date, options volume is still hopping — though it's far down from the 52-week high of 70.1 million options contracts traded in a day. In July, roughly 43 million options contracts are being traded daily, according to data from the Options Clearing Corporation . With covered calls, rising markets introduce an element of risk: Sell a covered call against a stock that takes off on a hot streak, and you miss an opportunity. Consider Big Tech names like Meta Platforms , which is up more than 160% in 2023, or Nvidia , which has popped more than 200%. META NVDA,.SPX YTD line S & P 500 versus Meta and Nvidia in 2023 To safeguard against this, investors can sell covered calls against just a portion of the shares they already own, rather than the entire position, Frederick said. This is known as an overwrite. "If you have 500 shares and a low cost basis, just sell one covered call against 100 shares of the stock," he said. "This way you still have the other 400 that you're making money on." If the underlying stock happens to tumble and falls short of the strike price, you can still pocket the premium. "Some people see it as a buffer for some limited downside protection," said Bryan Armour, director of passive strategies research, North America, at Morningstar. If your losses exceed the income you generated from premiums, however, you start to participate in those declines. Using ETFs to manage risk It's riskier for investors to try covered call strategies with an individual stock, but there is an array of exchange-traded funds that take a more diversified approach. See below for a few large ETFs that participate in the space. However, investors will need to do their homework to find the right ETF for their circumstances. One of the favorites in the market is JPMorgan Equity Premium Income ETF (JEPI) , which has brought in $10.6 billion in flows year to date and a 12-month rolling dividend yield of 10.5%. "It does take a little bit of a different stance: It's actively managed and it has a lower volatility stock portfolio," said Armour. That style differs sharply from the Global X Nasdaq 100 Covered Call ETF (QYLD) , which offers a 12-month trailing yield of 12% and brought in more than $1 billion in flows year to date. "The Nasdaq 100 has had some incredible runs, and investors missed out on those if they were in the covered calls strategy," Armour said. "In a year like 2022, I'm not sure the Nasdaq 100 covered calls strategy would feel defensive." Indeed, the QYLD returned -19% in 2022, while Nasdaq 100 fell nearly 33%. This year, the index is now up 41%, while the ETF's total return clocks in at roughly 21%. Before hopping into one of these ETFs, investors should know why they want to use a covered call strategy in the first place. "If it's for lower risk exposure, you can get some solid yield and build a defensive strategy using bonds and a 60-40 portfolio," Armour said. If you still want to take the covered call route via an ETF, understand the payout profile, the underlying strategy and the expected performance – especially because you can miss out on upside, he added. "When investors are less bullish about the market, it's easier for them to make this tradeoff because it would be a nice-to-have," Armour said. "This way you see some income immediately."