Dale Anderson used to sell cars. Now, at 75, he's working a few hours a day at home, in Muncie, Pa., and earning 15% to 20% a year investing in the stock market.
Despite tough conditions last year, Anderson "eked out" an 18% gain. His secret: covered calls.
Covered calls, the practice of selling call options on stocks an investor owns, or selling calls and buying the underlying stock at the same time, are becoming increasingly popular.
"Covered calls are a good income strategy in a down market, where you don't often end up having to sell the stock because it doesn't rise to the strike price of the call," said James Abbott, an adviser at Two Rivers Bank and Trust in Burlington, Iowa.
Huntington Bank's asset management arm has been using covered calls since November, said senior portfolio manager Peter Sorrentino. Investors believe certain major stocks will bounce back, and fearing they will miss out on that appreciation, are willing to pay a higher premium for such calls on those stocks; it's those premiums that can give the covered-call seller an income, Sorrentino said.
"We've been writing calls out one month for several months now, and getting 1% returns per month on our stock portfolio, which is pretty good in this market," he said.
Most of those calls haven't been exercised, so Sorrentino can keep selling new calls on the underlying stock each month.
Ron Groenke, a former software company executive who took a buyout and became an investment adviser in Marco Island, Fla., has written books and run seminars touting covered calls. He said this can be close to a risk-free way to create a positive income stream on a stock portfolio.
"The key is the 'covered' part. If you own the stock, you're not leveraged, so there is a limit to how much you can lose if the stock drops," Groenke said. "Your only real risk is an opportunity cost if the stock rises beyond the strike price of the call." The call buyer would take possession of the stock, but not until the seller had received the appreciation up to the strike price and the premium.
Groenke writes calls only on "good solid companies" — large-cap firms in the S&P 500 or Fortune 500 companies. He avoids companies with a market cap of less than $500 million. He then narrows his choices to companies that aren't trading near their highs. His stocks share a low probability of plunging and command a relatively high call premium.
James Knight, vice president of the options department at Raymond James, said four types of stocks are suitable for covered-call plays: "dogs," blue chips, growth and aggressive growth stocks. He rejects three of the four: dogs have too much downside risk; blue chips generally carry lower call premiums; and aggressive stocks could soar, causing a loss on the upside. But growth stocks "carry better premiums and have less downside risk," he said.
The Internal Revenue Service has approved covered calls for use in individual retirement account and 401(k) funds because the underlying principal is not put at risk as it would be with an "uncovered" call option. Only a few banks have approved it for advisers.
Bank investment policy committees are slow to approve covered call writing, because "people hear options and think risk and complexity," Knight said. And keeping track of exercised calls and strike dates, which occur on the third Friday of each month, is "extra work for the broker-dealer." That said, the process of selling calls is quite simple: Any broker who handles stock orders can also sell calls and handle the transaction if a call is exercised.
