Managing Covered Calls In Your Retirement Portfolio

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Includes: VZ
by: Matthew Frankel

My recent article, "Using Covered Calls to Supercharge Your Retirement Portfolio", was met with a flood of emails and comments, all raising some good points and questions. In this article, I would like to address the issues of having your shares called away when your stock goes on a bull run and holding "losers" when your stock's price falls significantly after you sell covered calls.

Some asked if I was underestimating the risk involved with such a strategy, and claimed that shares would get called away fairly regularly. While it is true shares could get called away in the event of a massive bull run, this is much less likely than you may think, considering my strategy of picking some of the lowest-volatility stocks I can find. Even if you do get one of your positions called away, isn't the goal of retirement savings to provide you with income, which you would definitely receive if your stocks were to rise to such a high level.

Another strategy that could be employed is "rolling over" a covered call into one that carries a higher strike price and expires at a later date Let's say that I owned 500 shares of Verizon (NYSE:VZ) on December 1st, 2011, when the stock was trading around $37.60, and decided to sell calls expiring in March 2012 with a $39 strike price. For this, you collect $0.49 in premium per share, for total proceeds of $245. As I write this, Verizon is trading at $39.09, which puts the call options you wrote $0.09 in the money with 7 trading days left before expiration. If you allow your covered calls to expire in the money, they will be called away. Of course, you can always allow this to happen, and, in this case, you will be forced to sell your shares for $39, nine cents below market value. However, you pocketed 49 cents per share when you sold the calls, and your trade "beats the market" by 40 cents a share, or $200 on a 500-share investment.

If you want to hold on to your shares, however, there is a second option. The March 39 calls are currently worth about 30 cents. Of this, 9 cents is the actual in-the-money value of the option, and the remaining 21 cents is the time value. Recall that the time value was 49 cents per share when this trade was opened. In other words, 28 cents of time value has "evaporated" since you sold your calls. In order to hold your shares, you will need to cover your outstanding calls. What you could do is to buy back your March 39 calls for $0.30 and sell June 40 calls for $0.62, for a net credit of an additional $160 in options premiums. You still own your stock, and are free to collect dividends while you wait out the time value of your newly sold calls. If the stock were to make another bull run, by the definition of options, some of the time value of your newly sold June 40 calls will have disappeared, and you could roll your covered call position into an even higher strike price. I employ this strategy often, and have only allowed myself to have been called out of shares once (JNJ went on a run from $61 to $65 and I was happy to take those gains and move on to another position).

On the other hand, what if, over the same time period, Verizon had dropped from $37.60 to, say, $35.00. Rather than say I was "stuck with a loser," I feel it would be in line with retirement investment strategy to view this as a buying opportunity. A price drop like this would cause Verizon's $2.00 annual dividend to create an annual dividend yield around 5.7%. In addition, the March 39 calls you sold would be nearly worthless, less than a penny actually given VZ's volatility. You could buy them back for a penny and sell a new covered call a little closer to the money and a little further out from expiration.

The bottom line is that there is no reason to have shares called away unless you want to. Sure you would give up a small amount of upside employing this strategy (9 cents per share in this example), but in exchange for the downside protection and added income that covered calls offer. When shares take a dive, a tremendous buying opportunity is created that allows you to increase your yields even further, as well as opportunities to cover your outstanding calls for next to nothing.

Disclosure: I am long VZ, JNJ.