OCEAN CITY – Most investors own a few stocks that seem to be in a holding pattern. Over the course of months or even years, their share prices may remain steady, trading sideways, or perhaps generating reliable returns, but gradually — over the course of months, or even years.
To help get more out of such holdings, you might consider an options strategy known as selling covered calls. This approach, which can help to generate additional income while you continue to hold your shares, works most effectively on positions for which you don’t anticipate significant near-term upward moves. "Covered calls can be a great way to outperform in down, flat or moderately up markets," says Jay Hanlon, Managing Director and head of Equity Market Solutions, part of Merrill Lynch’s Global Investment Solutions group.
Here’s how a covered-call strategy works: As the holder of a long equity position, when you sell a covered call, you collect "premium" income in exchange for giving someone the right to purchase your stock at a higher, fixed price — called the strike price — for a fixed period of time that ends on the option’s expiration date. By selling the call, you’re obligated to deliver the shares to the holder of the call if the price of the stock is above the strike price prior to the expiration date and they choose to exercise their right. On the expiration date, if the price of the stock is above the strike price, you will be obligated to deliver the shares. However, if the price of the stock does not rise to the strike price before that date, you keep the stock along with the premium you collected by selling the call.
"The trade-off you make in exchange for the premium income is the potential opportunity cost — if the stock price rises past the strike price by more than the income collected, you will have given up more upside than you received," explains Hanlon.
Sellers can choose from numerous expiration dates and strike prices, so clients with specific price targets for a given period of time can try to select a call that reflects their outlook. Since, like stock, options are typically traded on public exchanges, you can see what each month and strike price combination will generate in premium income at any time. As you might expect, the closer the strike price is to the current price and the further out the expiration date, the higher the premium will usually be.
In selling covered calls, the stockholder should be prepared to lose ownership of the stock (albeit at a higher price) — or to pay a significant premium to retain it — should the shares’ value soar. "If the stock is above the strike price and you decide you don’t want to sell it, you’ll need to buy back that call option before it gets exercised," warns Hanlon. And, he adds, depending on the price and other factors, such as time left before expiration, that cost can be considerable.
Like most investment strategies, there are risks involved. Covered calls only protect against small downward moves in the underlying stocks; you can still lose money if those stocks decline in price. Depending on your account type, you should also consider transaction costs, since you may incur commissions for each options transaction, as well as for any stock sales that occur if your shares are "called away." And, as with any investment, you should factor in the possible tax consequences of your approach.
Your financial advisor can run custom covered-call scenarios on a single stock or your entire portfolio to help you understand the potential return opportunities and trade-offs, as well as which calls might best fit your specific goals and outlook. Together the two of you can evaluate whether a covered-call strategy might be suitable for you.
(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)