Covered calls are a very useful, but rarely used strategy to increase returns before and after retirement. When used properly, effective call writing can double long-term returns in your portfolio.
Now, I am an advocate the use of stable, high-dividend stocks as an excellent strategy. The ideal portfolio should have between 5 and 8 diversified, high-yield stocks with a solid record of increasing their dividend. A few examples in my own portfolio are Verizon (NYSE:VZ), Johnson and Johnson (NYSE:JNJ), and Reynolds American (NYSE:RAI).
Let's suppose you purchase 200 shares of Verizon for your retirement portfolio at Tuesday's closing price of $38.69, an initial investment of $7738. Verizon is currently yielding 5.14%, so assuming the stock price goes nowhere, you still net a 5.14% return on your money. Not bad, right?
On the other hand, let's say that instead of simply letting your shares sit and collect dividends, you decide to put your shares to work. You sell 2 covered calls expiring in June at a $40 strike price. In other words, you are selling the right to purchase your shares for $40 before the contracts expire in June. For selling these calls, you collect a premium of 58 cents per share, or $116 in total.
There are two possible outcomes when using this strategy. First, and this is what I always hope for, is that the stock price remains under the $40 strike which we sold calls. The contracts you sold expire worthless, so you pocket the premium paid to you. In the meantime, you have collected a dividend from the shares, which you still own. You are now free to write new calls and the cycle repeats. Assuming that you write calls that expire 4 months out, and do this 3 times per year, this alone will produce a return of 4.6% on your investment. In order to maximize returns, all dividends should be reinvested and all proceeds from selling calls should be used to purchase additional shares.
How would this affect your returns over the long run? Let's say your ideal timeframe for retirement is 25 years and that you open an IRA and contribute the maximum of $5000 per year between now and then. If you invest in high-yielding companies, at an average dividend yield of 5%, after 25 years, your portfolio will be worth approximately $660,000 assuming you have reinvested all dividends and the stock prices increase at 7% a year, which is historically conservative.
If you had employed the above strategy and had been writing calls every four months, your annual return would be around 9.6% in dividends and call income alone and your portfolio after 25 years will be worth $1,370,000 assuming the same 7% stock price gains on average.
The second possible scenario is that the stock price goes above the strike price. In our case, this would mean our 200 shares of Verizon rose above $40 before the expiration date. In this case, our shares could be "called away" which means that you will be forced to sell your 200 shares for $40, or $8000 total. You also keep the premium you collected when you sold the call options, producing a total value of $8116. You are then free to invest this money in another high-yielding company and start the process again. This equates to a return of 4.9% over 4 months, which equates to an annual return of 15.4%. Not bad for a worst-case scenario.
When using covered calls, you are creating additional income while mitigating downside risk. The drawback is that you are giving up some potential upside in your position, in our example, the only scenario where you lose is if the share price rises to, say, $50. You are not entitled to any of your gains above $40. However, I am still in favor of this strategy because high-yielding dividend stocks generally do not exhibit drastic price swings.
The goal of a retirement portfolio is steady, predictable income. If a stock you like could realistically swing 20% every 4 months, it probably does not belong in your retirement portfolio in the first place.