Get Paid To Play Defense — The Easy Way
In turbulent times like these, investors are understandably skittish about depositing hard-earned assets into brokerage and 401(K) retirement accounts. But letting your cash languish in low-yielding instruments won’t do much to help build a comfortable nest egg either.
If only there were a door number three: a way to stay invested and protected. A way to earn dependable income (beyond dividends), even if the market stalls out or retreats…
Actually, there is. As I explained in this piece, covered call options are a great way for investors to enhance their income. They also lower risk by reducing your cost basis, since every premium you earn lowers your breakeven price.
But not everyone is comfortable trading individual options. That’s OK. For those of you who’d rather leave this strategy to the pros, there’s still a way to participate. I recently told my High-Yield Investing subscribers about a group of funds that were specifically created to take this concept and apply it on a much larger scale.
The Hands-Off Approach
Using my example of Pfizer in my last piece, if 100 shares can generate about $200 in yearly premium income, then 1,000 shares can give us $2,000 and 10,000 shares can net $20,000.
So, imagine the income potential for a closed-end fund that holds hundreds of thousands or even millions of shares.
Take the Nuveen Dow 30 Dynamic Overwrite (NYSE: DIAX). The fund invests in the 30 members of the Dow Jones Industrial Average and collects dividends on each. But unlike a plain vanilla index fund, it also sells covered call options to generate additional income and enhance risk-adjusted returns.
The fund holds shares of Boeing (NYSE: BA), Cisco (Nasdaq: CSCO), Coca-Cola (NYSE: KO), and Wal-Mart (NYSE: WMT), among others. And it sells options on roughly 50% of the fund’s holdings, sweetening the dividends with premium income that allows for a robust distribution of about 9%.
Keep in mind, while the underlying premise is the same, there are different applications of this strategy. Within the options section of the portfolio, three factors you’ll want to consider are the average strike/spot price ratio, weighted average number of days to maturity, and average call option overlay as a percentage of total fund assets. This will yield some insight on how much potential appreciation the fund manager is willing to trade away for current income.
It’s common for these covered call funds (also known as “buy-write” funds) to have an options overlay representing between 30% and 60% of assets. That’s enough to enhance income and be an effective risk management tool, while still leaving the rest of the portfolio unencumbered to participate in a rising market.
Benefits And Drawbacks
These funds will usually lag in a runaway bull market. But that’s to be expected. They perform best when those bull markets begin to stall out and cool. To demonstrate, just look back a few years to 2015. The S&P 500 inched up just 1.4% that year. But as advertised, the PowerShares S&P 500 BuyWrite Portfolio (NYSE: PBP) delivered a much stronger return of 4.5%.
Current conditions favor this strategy. And the extreme price swings we’ve been seeing make it even more compelling. Remember the $0.46 per share option premium I cited earlier? It’s not set in stone. Premiums can vary wildly from a few pennies to several dollars per share, depending on certain variables. The more a stock price fluctuates, the more profitable a call option can be — and the more buyers are willing to pay.
That’s always a good thing when you’re the one on the selling end of the transaction. In other words, this market volatility could be an ally.
As one final incentive, consider that covered-call funds can support outsized distributions without the aid of leverage. Most do NOT borrow money, making them less vulnerable to rising rates than other closed-end funds.
Want To Know My Favorite?
Of course, not all of these funds are created equal. DIAX and PBP are certainly worthy of consideration, but neither one of these if my favorite.
Instead, we hold a well-managed fund in the High-Yield Investing portfolio that holds some of the best value stocks on the market. As I told my subscribers back when we added it, I think we’re about to see value stocks come back into favor in a big way very soon.
Unfortunately, if you’d like to get the name of this pick, you’ll have to be a High-Yield Investing subscriber. (You can learn more here.) Either way, covered call funds will shine in this environment, acting as a hedge against a directionless market. So if you’re looking for some protection and a little extra income, it would be wise to look into them.