Investment alternatives, such as equity, fixed income, and commodities, come with embedded income properties. The amount of income paid to investors is generally related to the issuer's ability to generate ongoing cash flows and to access alternative uses of funds for future growth opportunities.
Understandably, income-focused investors often are underweighted in high-growth stocks, since these stocks pay no dividends, or have low dividends, as they preserve cash for growth opportunities. At the same time, these investors may take on higher amounts of interest rate risk, because they are holding more fixed income than they would otherwise own if they were selecting investments based on total return. Investors with a high preference for current income also may avoid gold or other commodity allocations because these generate no income.
What are the options for an investor who has specific income goals for his or her investment portfolio? Attaching a high weight to an investment's income properties in deciding how much to hold means missing certain types of investments that are key parts of the economy (e.g., technology), or that offer desirable diversifying properties (e.g., commodities, such as gold, oil, and agricultural goods). This leaves income investors forgoing certain investment opportunities. Furthermore, investors are less diversified than they otherwise would be if they selected investments based on total returns.
Using Options as an Income Source to Monetize Risk
There is a solution for achieving income goals that can be utilized with any type of investment that has some component of price volatility. The sale of call options against a portion of a position converts upside risk (i.e., opportunity for capital gains) into current income in the form of an upfront option premium. Most stocks, ETFs, and commodities have options available that allow buyers to participate in a portion of the returns above a strike price.
At-the-money (“ATM”) and out-of-the-money (“OTM”) call options sell for prices related to the likelihood of the underlying security or commodity price moving above the strike price at the expiration point. This likelihood is related to expected volatility for the underlying security, index, or commodity over the time remaining to expiration, which is a function of market-wide factors, as well specific events that could occur for the underlying investment.
Covered call strategies have been around for decades but have primarily been utilized in their most simple form—the sale of a covered call option against an entire holding, based on a target selling price for a stock, commodity, or exchange-traded fund (“ETF”). This maximizes the income component of returns from covered call writing but eliminates a sizable component of upside capital return potential. Therefore, many covered call investors turn away from the strategy as soon as capital returns become significant and they see that the opportunity cost of covered call positions can be high when they are used simply to maximize income. Others choose not to utilize covered call strategies at all because they reduce expected returns compared to a fully invested position. In many cases, investors have entered a call option selling strategy for the benefits of the high income without developing an appropriate benchmark for total return expectations that incorporates the significant reduction in upside opportunity from setting a cap on returns.
Selling calls against the entire position of an equity holding typically takes risk down 25% to 50%, depending on the "moneyness" of the short call—how far the strike price of the option is from the stock price at the time the call option is sold. Such a major risk reduction sets it apart from other strategies in the investor’s equity holdings and makes the fully covered call strategy much less rewarding from a total return perspective. If the investor does not increase the size of the position or reduce the return expectation, the covered call strategy will likely disappoint in the long run, since most investors care as much about total return as they do income.
Monetizing Risk Consistent with Income Targets as the Strategy Design Criteria
An alternative approach is for the investor to have an investment objective that specifies the proportion of total return that comes from income and capital return. Of course, the capital return component is subject to the risk of the market, and ex-post returns can be higher or lower than the expectation. The income target, on the other hand, can be achieved with a limited covered option strategy designed to hit the income target. This is, in fact, the essence of the Target Income Strategy® invented by Cboe Vest. The key decision variables in the strategy design are the selection of the investment positions to "cover," the portion of the position to cover (e.g., 10%, 20%), and the choice of call options in terms of expirations and strike prices.
These option strategy design decisions are interrelated, but the core approach is to use covered call writing in moderation with a realistic income target in mind that also allows the investor to participate in upside capital returns. This can be done by covering only a small portion of the holding, using short-term options that reset the strike price regularly to allow for changes in the price of the underlying investment, or applying out-of-the-money options that truncate only a portion of the upside return distribution. Further, the portion of an investment overwritten can be calibrated to the level of risk of the investment and adjusted as risk levels change with market conditions. When volatility is high, the portion overwritten can be lower. It can also be lower for more volatile investments that have higher potential total returns, and higher for investments that have less potential upside to monetize.
Example of Target Income Strategies
Consider two investment alternatives—Alpha and Omega—both priced at 100. Alpha has income of 2% annually and volatility consistent with that of the broad equity market at 15% annually. Omega is a growth stock that pays no dividend and has risk of 25% annually, much higher than the equity market. For this example, we will assume the investor has a target income of 5% per year. Therefore, the covered call strategy should be structured to generate 3% income annually for positions in Alpha, and 5% annually for positions in Omega. Target Income Strategy design would suggest a few alternatives for each position, depending on the options used.
In Figure 1 below, a typical set of assumptions and a Black Scholes option pricing model is employed to calculate call option prices on Alpha and Omega for one month of call options ATM (100) and 1% OTM (101). These are then used to determine the size of the short call position expressed as the percentage of the position that is covered to generate the target annual income. Note that both strategies provide 5% income per year. Alpha's income consists of a 2% annual dividend yield, along with 3% from option premia; the riskier stock, Omega, generates all of its 5% income from the sale of call options.
Figure 1: Examples of Solving for the Portion of Portfolio Covered to Deliver Target Income
|Target Income from Covered Calls->>
|One-Month Call Option Value
|ATM (Strike Price 100)
|OTM (Strike Price 101)
|Percent Covered to Provide Income
|ATM (Strike Price 100)
|OTM (Strike Price 101)
Source: Options Industry Council website Options Calculator: https://www.optionseducation.org/toolsoptionquotes/optionscalculator (Assumptions in table for European option).
For both Alpha and Omega, the portion of the position covered to achieve the income target is in the range of 14% to 20%, depending on whether the investor chooses to use ATM or OTM options. This leaves at least 80% of the position uncovered with the opportunity to earn full upside appreciation, clearly placing the investment strategy in the equity category, albeit with lower risk than the average stock position and higher income.
Note that the riskier stock (Omega) has higher prices on its call options since it has higher expected volatility and lower dividends (a call buyer forgoes dividends which he or she would earn when holding the stock). A one-month ATM call option on Omega would likely be priced at 2.883, or 1.75 times the price of a call option for Alpha ( 1.656), with the same strike price and expiration. Therefore, even though Omega pays no dividend income and requires the investor to generate the full 5% income target from the sale of call options, the portion of the position covered is slightly lower because of the higher call option premium. This leaves more room for upside capture on the riskier stock.
The investor has a choice to apply the strategy to a smaller portion of the position using options ATM or to cover a larger portion with OTM options. Using ATM options provides the highest income and, therefore, requires the smallest allocation to generate the target income, leaving the remainder of the position to earn the full upside of the underlying securities or commodities. Covered call positions that use OTM options provide some potential capital return up to the strike but have lower option prices. Therefore, a larger portion of the position needs to be covered to generate a specific level of target income. Both of the strategy design alternatives shown in this example still leave significant upside capture for the investor holding either Alpha or Omega
There are some differences in the total returns of selling ATM versus OTM options in a Target Income Strategy, even though they both generate the same level of target income by design. The OTM approach will likely deliver better returns in flat- to moderate-return scenarios because the options may not be exercised at all. Meanwhile, the ATM strategy will be superior in very high capital return scenarios because the portion of the position needed to be covered is lower due to the higher option price. Another way the strategy design can be modified is to sell options to generate the target income with longer terms to expiration (e.g., two or three months). This approach would likely increase the income received per option but give the investor fewer times during the year to reset the strike price and sell more options. Therefore, the portion of the position covered would tend to be higher.
Target Income Strategies Give Income Investors a Wider Choice Set
Having the flexibility to adjust the income features of an investment strategy can expand the scope of investments that can be considered viable for investors with significant income goals. Limited use of covered call strategies gives investors the opportunity to customize the mix of income and potential capital appreciation consistent with their income goals without restricting the types of investments in their portfolios. Investors who favor technology stocks that pay little or no dividends, or who want to hold commodities for diversification or price appreciation, can do so and generate current income. They simply have to adopt a strategy that monetizes some of the upside potential on a consistent basis. This will mean forgoing some (typically less than 20%) of the potential total returns as the upside risk and opportunity are taken down by the income strategy. However, this can be compensated for by holding a larger position in a low-income stock or commodity or by combining it with other high total return opportunities elsewhere in the portfolio.
The key takeaway is that investment income can be created for any security or commodity with call options, and there are alternative strategy designs available based on the option term and strike price. Target Income Strategies using covered call options on a small portion of a portfolio can generate a significant boost to the income component of total return. Selling call options does alter the return and risk profile of the underlying investment, reducing its risk and sensitivity to price moves. However, as long as this is considered when evaluating and managing the investment opportunity, the investor can end up with a wider range of alternatives for achieving his or her income goals.
The Target Income Strategy, offering exposure to high-quality, Dividend Aristocrats, is available in both a mutual fund and an ETF. The Target Income Strategy, with exposure to gold, is available in an ETF.
Appendix: Terminology of Covered Call Writing as Applied to Stock Positions
Covered call strategy: A covered call strategy is a strategy in which an investor owns (or “holds a long position in”) a stock and sells (or “writes”) call options on that same stock. By selling the call options, the seller gives up the right to the stock’s future price appreciation above the strike price and receives an upfront premium payment as compensation. The covered call strategy gives the seller the unique ability to convert a stock’s uncertain future returns into certain upfront premium income.
Full (or fully) covered call selling strategy: A full covered call strategy is one in which the investor sells calls against the entire long position on the stock. (Put another way, the investor sells calls on every share of stock owned.) This means the investor gives up future price appreciation of the stock above the call strike price in return for the upfront premium.
Partial call selling strategy: A partial call selling strategy is one in which an investor sells calls on a small percentage of each stock holding. A partial call selling strategy would collect a lower level of premium income but would also give up only a portion of the future returns. A partial covered call selling strategy allows an investor to strike the appropriate balance between the upfront, predictable premium income collected and the future returns given away.
At the money (ATM): At-the-money options have a strike price that is exactly at the prevailing price of the underlying stock.[i]
Out of the Money (OTM): A call option is considered OTM when the call option's strike price is higher than the prevailing market price of the underlying stock. It confers the right to buy the underlying stock at a higher price than the prevailing stock price, and hence it has no intrinsic value.[ii]