Case study: using covered calls to enhance portfolio performance

Introduction:

In the world of investing, finding ways to enhance portfolio returns while managing risk is a constant challenge. One strategy that has proven effective for many investors is the use of covered calls. Covered calls involve holding a stock and selling call options on the same stock to generate premium income. This approach not only provides a steady stream of additional income but also offers a layer of protection against minor declines in the stock price. However, it does cap the potential gains if the stock price rises significantly. For investors looking for a balanced approach to generating income and managing risk, covered calls can be a valuable tool.
 
Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.

Background:

John, a seasoned investor, owns 500 shares of Fictitious Inc., an imaginary company created for the purpose of this case study. Fictitious Inc. is currently trading at $100 per share. John has been investing for several years and has built a diversified portfolio. While he is confident in the long-term potential of Fictitious Inc., he is looking for ways to generate additional income from his holdings. John believes that by using strategic options, he can enhance the yield of his portfolio without taking on excessive risk. He aims to achieve a higher return on his investment while still holding onto his shares for future appreciation.

Challenge:

John seeks additional income but is cautious about short-term volatility. Although he believes in the long-term growth prospects of Fictitious Inc., he is aware that the stock market can be unpredictable in the short term. To address this, John is looking for a strategy that allows him to earn extra income during periods of low volatility while protecting his portfolio from significant short-term declines. He wants to make sure that any strategy he employs does not compromise his long-term investment goals or expose him to undue risk.

Solution: Using Covered Calls:

John sells 5 call options on Fictitious Inc. with a strike price of $110, expiring in 30 days. He receives a premium of $1.5 per share, totaling $750.

Financial Comparison:

• Current Holdings: 500 shares of Fictitious Inc. at $100 each, totaling $50,000.
• Call Option Sale: John receives $750 in premiums.

Outcome and Analysis:

• If Fictitious Inc. trades at $100 at expiration:
  • John retains his shares and the $750 premium. His effective sale price, considering the premium, is $101.5 per share. This means he earns additional income without losing his shares.
• If Fictitious Inc. trades at $90 at expiration:
  • John retains his shares and the $750 premium. The effective sale price is $91.5 per share, softening the loss from the decline in stock price.
• If Fictitious Inc. trades above $110:
  • John sells his shares at $110, gaining $5,000 from the stock sale plus the $750 premium, totaling $5,750.

ROI and Yield:

• Annualized Return: The $750 premium for 30 days translates to an annualized yield of approximately 18%. This is calculated as ($750 / $50,000) * 12 months.
• Enhanced Yield: John increases his portfolio's yield by 1.5% monthly or 18% annually. This additional yield is a significant boost to his overall returns, showing how covered calls can generate extra income.

Conclusion:

By integrating covered calls, John not only generates additional income but also manages risk effectively. This strategy enhances portfolio performance by providing a steady income stream and some protection against minor declines. However, it limits potential gains if the stock price rises significantly and doesn’t protect against substantial drops. This balanced approach makes covered calls a versatile tool for investors seeking to optimize their returns while managing risk.