The central banks' coordinated efforts to stave off a bank run will only lead to more monetary easing. There is limited political will for further fiscal policy adjustments in the U.S. The supper committee was unable to pass any meaningful changes. The political situation in Europe seems to be worse. We believe this political gridlock is why the world central banks continue to ease.
Markets were euphoric on Wednesday, with the DOW and S&P 500 up 4 percent. We recommend that investors use this rally to sell covered calls on some of their existing positions. We think that the euphoria will be short-lived, as the underlying issues have not been addressed. For long-term holdings (such as the stocks on the list below), investors can use the market rally to generate additional income.
Why Not Just Sell?
Since we think the market will remain choppy and range-bound for the next 3-6 months, covered calls offer investors an alternative to selling out of their long-term positions by giving them an opportunity to generate short-term income while keeping some upside intact.
Yields on high-quality, dividend-paying stocks are well above the 10 year U.S. Treasury. These equities are low levered and provide steady dividend yields to investors. Options can augment already attractive dividend yields and offer some limited downside protection. In addition, investors can generate a synthetic dividend from covered calls for long-term trades such as Too-Big-To-Fail financials and high growth equities. Although these equities are inherently more speculative, selling options will allow holders to keep their long-term thesis intact while utilizing the elevated implied volatility to their advantage.
Covered Call Recommendations
Below are examples of various stocks that we feel will benefit from a covered call strategy, including: (i) attractive high, quality dividend paying stocks; (ii) speculative financial stocks that fall under our too big to fail thesis; or (iii) high growth equities. While the three groups convey different risk profiles, we think all three groups can leverage options strategies to generate income.
For option newbies, we encourage you to educate yourself before employing this strategy. A good place to start is the Options Industry Council.
Covered Call Basics
The covered call is a strategy in which an investor writes a call option contract (for an equivalent number of shares) on a stock that the investor already owns. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership.
Though the covered call can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.
While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.