Generating Potential Income: Options Edition
David Furst, CFA, Advice Strategy
Taylor McLeod, Analyst
When investors near retirement, attention often turns to generating income from their portfolios as regular paychecks become a thing of the past. With life expectancies in the United States hovering around 80 years, that could leave decades of retirement for which investments are relied upon for living expenses. With such a long span of time to cover, forward-thinking investors are seeking more ways to potentially generate income from their investments.
This report will not focus on bond investing (a common income strategy) but instead will highlight a supplementary strategy designed to generate income in a portfolio that may be appropriate for some investors: an options strategy. Although options carry additional risks and complexity beyond that of more traditional asset classes (such as stocks and bonds), some option strategies may be utilized to generate potential income, since many investors already hold a diversified portfolio of equities. More specifically, a strategy known as covered call writing can leverage the existing ownership of a stock by pairing it with a short position in a call option on that stock.
Call Option: The buyer of this option receives the right (not the obligation) to purchase shares of the underlying stock at a predetermined price at some point in the future.
Strike Price: The price at which the option buyer can pay for the underlying stock.
Market Price: The price at which the underlying stock is currently trading in the open market.
Expiration: All options have expiration dates. The option buyer must decide to exercise their option by this date, or the option expires.
Exercise: If the buyer of the call option decides to ‘exercise’, they notify the option seller that they wish to purchase the shares of the underlying stock at the pre-determined ‘strike’ price regardless of the current market price of the stock.
When an investor sells (or ‘writes’) a covered call option, they are giving the option buyer the right (but not the obligation) to purchase shares of stock they hold at a predetermined ‘strike’ price per share (regardless of what the market price may be). In return, the seller would receive a ‘premium’. The option seller keeps the premium collected no matter what happens to the market price of the underlying stock. If the stock price were to rise above the strike price, the seller may be obligated to sell the underlying stock when the call option is exercised. However, if the stock prices does not rise as high as the strike price (or declines), the seller retains the premium and the shares.
Covered Call Writing
Mary holds 100 shares of XYZ Corp. in her portfolio but desires additional income from the position in the stock. She decides to write a covered call option in XYZ Corp.’s stock. Commission, taxes, and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered.
Background Information: Purchase price of XYZ Corp. is $50. Mary sells one call option contract (covering 100 shares) with a strike price of $75 expiring 6 months from now. Mary receives $3 per share (the option ‘premium’).
When Mary attempts to augment her stock position by selling a call, she is limiting her potential gains, in exchange for the income provided by the option premium. However, the option premium is dependent on a variety of factors including the characteristics and volatility of the underlying equity shares, the length of time until the option expire, the strike price chosen, and more.
This common options strategy may be appropriate depending on the investor’s individual risk tolerance, comfort level with derivative financial products and many other factors.
Consult with your financial advisor if you think an alternative income generation strategy may be appropriate for you.
Options: Options involve risk and are not appropriate for all investors. Before opening an options position, please read “Characteristics and Risk of Standardized Options” carefully before investing. This document is available from the Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, Illinois 60606. Supporting documentation for any claims, comparison, recommendations, statistics, or other technical data will be supplied upon request.
RESEARCH, CHARTS, AND ILLUSTRATIONS PROVIDED BY JUANA DIEZ DE ONATE – INVESTMENT IMPLEMENTATION ANALYST
All investing involves risk, including loss of principal. When participating in a covered call strategy, the investor is at risk of having to sell the underlying stock if the stock’s price rises above the sold option’s strike price. Remember, in exchange for receiving the premium of having sold the call, the investor is obligated to sell the underlying stock via assignment if the option is exercised. The cost of retaining the shares may exceed the net premium received. Keep in mind that if the stock price falls, you are still a stock owner, and are subject to the full loss of your stock investment, reduced only by the credit from the sale of the call.
Covered Call Selling is not a protective strategy. Also, keep in mind writing an option on a stock with a low cost basis, there are tax consequences to consider upon assignment. Because of the importance of tax considerations to all options transactions, investors considering options should consult with their tax advisor to evaluate how taxes can affect the outcome of contemplated options transactions. Please keep in mind any profits may be reduced or losses worsened, as applicable by the deductions of commissions, fees, and taxes.
ASSET CLASS DISCLOSURES
Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Investments in equity securities are generally more volatile than other types of securities. Technology and Internet-related stocks, especially of smaller, less-seasoned companies tend to be more volatile than the overall market. There is no guarantee that dividend-paying stocks will return more than the overall market. Dividends are not guaranteed and are subject to change or elimination.
Investments in fixed-income securities are subject to market, interest rate, credit, and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk than an issuer will default on payments of interest and/or principal. This risk is heightened in lower-rated bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
The investment strategies discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Additional information is available upon request.
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