By Philip van Doorn
Interest rates have remained persistently low even as the economy emerges from the pandemic.
The yield on 10-year U.S. Treasury notes /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y 0.00% hasn’t been above 2% for more than two years. (It’s yielding 1.32% on Monday.)
As a result, many income-seeking investors have migrated from bonds, considered the safest income investments, to the stock market. But the income from a diversified stock portfolio might not be high enough.
There is a way to increase that income, even while lowering your risk.
Below is a description of an income strategy for stocks that you might not be aware of — covered call options — along with examples from Kevin Simpson, the founder of Capital Wealth Planning in Naples, Fla., which manages the Amplify CWP Enhanced Dividend Income ETF /zigman2/quotes/208452653/composite DIVO +0.18% .
This exchange traded fund is rated five stars (the highest) by Morningstar. We will also look at other ETFs that use covered call options in a different way, but with income as the main objective.
Covered call options
A call option is a contract that allows an investor to buy a security at a particular price (called the strike price) until the option expires. A put option is the opposite, allowing the purchaser to sell a security at a specified price until the option expires.
A covered call option is one that you write when you already own a security. The strategy is used by stock investors to increase income and provide some downside protection.
Here’s a current example of a covered call option in the DIVO portfolio, described by Simpson during an interview.
On Aug. 23, the ETF wrote a one-month call for ConocoPhillips /zigman2/quotes/207605056/composite COP -0.83% . At that time, the stock was trading at about $55 a share. The call has a strike price of $57.50.
“We collected between 70 cents and 75 cents a share” on that option, Simpson said. So if we go on the low side, 70 cents a share, we have a return of 1.27% for only one month. That is not an annualized figure — it shows how much income can be made from the covered-call strategy if it is employed over and over again.
If shares of ConocoPhillips rise above $57.50, they will likely be called away — Simpson and DIVO will be forced to sell the shares at that price. If that happens, they may regret parting with a stock they like. But along with the 70 cents a share for the option, they will also have enjoyed a 4.6% gain from the share price at the time they wrote the option. And if the option expires without being exercised, they are free to write another option and earn more income.
Meanwhile, ConocoPhillips has a dividend yield of more than 3%, which itself is attractive compared with Treasury yields.
Still, there is risk. If ConocoPhillips were to double to $110 before the option expired, DIVO would still have to sell it for $57.50. All that upside would be left on the table. That’s the price you pay for the income provided by this strategy.
Simpson also provided two previous examples of stocks for which he wrote covered calls:
DIVO bought shares of Nike Inc. /zigman2/quotes/203439053/composite NKE 0.00% for between $87 and $88 a share in May 2020 after the stock’s pullback and then then booked $4.50 a share in revenue by writing repeated covered call options for the stock through December. Simpson eventually sold the stock in August after booking another $5 a share in option premiums.
DIVO earned $6.30 a share in covered-call premiums on shares of Caterpillar Inc. /zigman2/quotes/203434128/composite CAT +0.92% , which were called away “in late February around $215-$220,” Simpson said. After that, the stock rallied to $245 in June, showing some lost upside. Caterpillar’s stock has now pulled back to about $206.