Protect Your Portfolio with Covered Calls

The stock market’s rebound from the lows of March has been amazingly strong and is beginning to make many wonder whether stocks have become overvalued again. Without doubt, the lack of desirable alternatives to stocks continues to fuel the rally. Stocks may no longer be such a bargain, but with cash yielding nothing and 10-year treasury bonds yielding 3.4%, what are the options?

For those who are not eager to accept the low yields offered by cash and bonds and are nervous about enduring the volatility of the stock market, I propose an alternative: selling call options against stock holdings (also known as writing covered calls). This strategy generates income and reduces the risk of the portfolio, while giving up some of the upside of holding stocks. I consider this a particularly attractive strategy for those who are retired or near retirement and need to derive an income from their investment portfolio. As stocks are called away (when their price is higher than the strike price at expiration) the equity part of the portfolio is reduced and stocks are sold at prices that have been determined to be acceptable.

Following are the 12 largest companies in the S&P 500 by market capitalization, all of which are widely held stocks. In each case calculations are based on call options expiring in January 2011 with a strike price ranging from 5-20% higher than Thursday’s closing price. “Return if exercised” does not include dividends, which in some cases can be significant, especially when compared to current bond yields.