A covered call is an investment strategy that involves selling a call option on a particular asset. It’s a type of insurance that’s used against potential volatility. It is also often referred to as a “buy-write” in the financial field.
The goal of these is to profit if the asset goes up in price. Generally, the seller is obliged to pay a premium to purchase the call. Before exchange-traded funds (ETFs) were allowed to trade, these financial strategies were only available to sophisticated options traders.
A Financial Strategy That Equal Success
According to tastytrade, “A covered call is a common strategy that is used to enhance a long stock position”. The key to this successful strategy is when the volatility of the S&P 500 rises.
This strategy allows the buyer to profit from the rise in the stock’s value while protecting themselves from the downside risk. The perceived risk associated with this strategy is linked to the expected long-term returns. Since the call option seller is usually taking a high risk, their returns are typically low.
Benefits of Using Covered Call Strategy
- Guards Against Volatility
Due to the lower volatility associated with a buy-write strategy, it has been known to outperform the S&P 500 during times of high volatility. This strategy can also be used in times of unstable political conditions. Jonathan Molchan, a portfolio manager for the Horizons Nasdaq-100 Fund, noted that this strategy can help minimize volatility by delivering lower volatility than the broader market.
For investors in the QYLD, a monthly buy-write strategy provides them with at least two benefits. First, it increases their monthly income. Second, it provides them with downside protection.
- Offers Different Pattern of Returns
The performance of buy-write ETFs will vary depending on the year. In most cases, they will perform better in bull years when the market is still advancing slowly and consistently. A buy-write strategy can also produce better returns than the S&P 500 when volatility levels are elevated. When the bearish sentiment gets high, buy-writes are a good alternative to giving up your stock in the market.
- Simplified Strategy
Unfortunately, many investors are not aware of the many advantages of using a buy-write strategy. This is one of the main reasons why these ETFs are so popular. Unlike traditional mutual funds, buy-write ETFs don’t require investors to exercise their options early. Instead, they are managed by a team of experts.
- Premiums Can Be Kept as Income
Many investors use buy-writes to increase their monthly income. They typically sell them regularly and hope to add a few percentage points to their annual returns.
- Helps Set Target Selling Price
For instance, let’s say that an investor purchased a stock for $39.30 and sold it for 90 cents per share. The buy-write assignment means that the investor must sell the stock at the current price of $40.50 to receive the full amount of $40.90.
- Limit Downside Protection
The investor’s break-even point has been reduced by selling the stock. However, the protection that’s provided by selling a buy-write is very limited.
A buy-write is a two-part strategy that involves buying a stock and selling calls. The former is typically sold on a share-for-share basis. Buy-writes have several advantages for investors. They can provide them with income in a bullish market, protection against the downside and a selling price higher than the current market price.