This Risk-Reducing Income Strategy Could Yield 25%-35% Annually

In today’s low interest rate environment, it’s tough for investors to find a way to generate reliable income without taking on a significant amount of risk. Treasury securities are now considered “return-free risk” securities (instead of “risk-free return”), and other traditional fixed income investments have been bid up to levels where their yield is negligible.

So there are now two choices for investors: Either accept the fact that your assets no longer produce meaningful income, or leverage your investments (taking on significantly more risk) in order to collect larger dividend checks or bond coupons.

Or maybe there is a third option…

One idea for investors who need reliable income is to use a covered call writing strategy. In my days as a hedge fund manager, we used this strategy in the fund that I ran — and also in individual accounts for our investors — to set up trades that typically offered a 25% to 35% annualized return.

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This stable return can be pulled out as income for expenses and standard distributions, or it can be reinvested in the portfolio for even larger profits.

The beauty of this strategy is that it actually reduces overall portfolio risk, while generating reliable cash flow on a monthly basis.

Of course, in the world of trading and investing, nothing comes free. So when I tell you that you can reduce risk, while increasing income, you should immediately be skeptical and ask what you are giving up for these benefits.

The covered call strategy has one significant drawback: You’re not going to shoot the lights out with this approach, because in order to gain the additional income and reduced risk, you have to give up some of your potential upside. I’ll explain how this works in just a minute.

At any rate, considering the fact that the overall market is relatively extended and income is hard to come by, a strategy that consistently generates 25% to 35% is a pretty attractive proposition.

Let’s take a look at how this strategy works using a real-time trade example that you can put in your portfolio today.

Improving Employment Environment Boosts Discount Retailer

We’ll start with Big Lots (NYSE: BIG), a discount retailer serving budget-conscious consumers. The stock is currently trading at a discount as investors worry that a slow-growth economy will continue to pressure consumers in this demographic.

But lately, the environment has been turning. The unemployment rate hit a new four-year low this past month, and the consumer credit statistics indicate that consumers are willing to take on more credit card debt as they boost spending.

We can debate the sustainability of these developments, and I’m not sure that I would bet that the improvement continues long term. But for now, the improvement in consumer spending is helping the shares of Big Lots move higher.

Earlier this month, BIG stock surged more than 6% higher on the day the company released earnings. Big Lots announced fiscal fourth-quarter earnings of $2.09 versus analyst expectations for $1.99. More importantly, management issued positive guidance for the year ahead.

As you can see in the chart below, BIG is trading higher out of a basing pattern as institutional and retail investors alike accumulate shares.

BIG Stock Chart

On Monday, BIG closed at $35.87, which is the price we’ll use for our covered call example.

For our covered call position today, we’re going to buy BIG at the current price, and sell the April $35 calls, which were recently bid at $2. To do this, you need to buy BIG in lots of 100 shares, and then sell one call contract for every 100 shares.

A Quick Options Overview

If you’re not familiar with options, the buyer of a call option contract has the right, but not the responsibility to buy 100 shares of stock at the strike price (in this case, at $35).

Typically, this right is only exercised on the expiration date — the third Friday of every month. So in this case, the BIG April 35 Calls will expire on April 19. This means we have 38 days left until expiration.

Looking at the call option from the perspective of the seller (we sold the April $35 calls), we have the obligation to sell our 100 shares of BIG for every call contract that we have sold, provided that the price of BIG is at or above $35 on April 19. (Keep in mind that if the stock closes below $35, the call owners will not want to exercise their right because they could buy the stock cheaper in the open market).

Assuming you are able to put the trade on using the prices in this example, you should be invested at a net cost of $33.87 (the $35.87 cost of the stock, less $2 per share that you received from selling the calls).

Take a look at a few different scenarios for how this trade could work out:

Scenario 1: BIG Trades Lower

Let’s look at the worst-case scenario first. If our analysis or our timing for BIG turns out to be wrong, the stock could trade lower. Let’s assume BIG has a 10% decline, losing $3.59 in value. This would bring the stock down to $32.28.

If on April 19, the stock is trading below $35, the owner of the call contracts will not want to exercise the option to buy our shares at $35. So the call contract will expire worthless, allowing us to keep our shares and the $2 per share we made selling the call.

So even though our stock position dropped 10%, our total loss is actually less than 5% percent because of the cash that we received for selling the calls. Also, we still have our stock, which we can elect to sell more calls against (possibly the June $30 calls) to set up a new covered call position.

As you can see, in an environment where our stock actually declines, the covered call strategy saves us money, taking risk off the table.

Scenario 2: BIG Trades Flat

In our second scenario, Big Lots remains range-bound, closing on April 19 near our original purchase price of $35.87. A traditional investor who simply bought the stock would have no return on his or her investment. But since we sold calls against the position, we actually get to recognize a gain.

Now remember, the owner of the calls has the option to buy stock from us at $35 per share. So since the stock is trading above the strike price, they have an incentive to “exercise” their option.

We now have an obligation to sell our stock at $35, recognizing a loss of $0.87 per share on the stock portion of our investment.

Since we sold the calls for $2 per share, our net gain on the trade is $1.13. This actually represents a 3.2% gain over the 38-day period. On an annualized basis, this comes out to a 30.7% rate of return — not too shabby for an investment that actually reduces the amount of risk that a traditional investor would assume.

Scenario 3: BIG Rallies

In the final scenario, we’ll assume that Big Lots actually has a significant rally. Let’s say that the stock moves 10% higher to a price of $39.46. In this example, a traditional investor who simply bought the stock would be sitting on a 10% return.

Keep in mind that this investor took all of the risk in owning the stock while we effectively hedged our position, writing calls to protect ourselves against much of the risk.

So, in this instance, we would still recognize our full expected gain of 3.2% for 38 days (a 30.7% annualized return), but we would give up the potential for a larger gain if BIG continues to rally.

Essentially, the covered call strategy gives us reliable income and moderate protection from falling stock process. In return, we give up the potential for home-run gains if the stock rallies sharply.

Flexibility for Growth and Retirement Accounts

One of the great advantages of the covered call writing strategy is that it can be used with a number of different types of accounts.

Just last week, I had a conversation with another dad at the baseball field while watching my son play third base.

My friend had just decided to roll his 401(k) into an IRA account and his plan was to trade a portfolio of covered call positions in this account. He knew that over the next several years, he could reliably generate a very healthy return on his retirement account, while accepting much less risk than most of his colleagues.

Covered call positions can be traded in a traditional brokerage account, in an IRA or Roth IRA account, and in some cases in a self-directed 401(k) account as well.

Even if you don’t need the income right away, writing covered calls can be a great way of growing your assets by an annual rate of 25% to 35% (a pretty attractive return) while significantly reducing your overall investment risk.

Later this week, we’ll cover some additional details about which call contracts to pick when setting up a covered call position. But in the meantime, I’d love to hear what you think about this strategy.

Is this an area you would like to develop more expertise in? Would you like to see additional examples of how you can generate reliable income with significantly less risk on a monthly basis?

I would love to hear from you. Please shoot an email to Editors@ProfitableTrading.com and mention this article on covered call writing.