Consider a covered-call strategy

If the coming months are volatile, you could find covered-call strategies an attractive way to backstop your portfolio.

Covered-call writing on a single stock position is straightforward. You own the stock and are reluctant to sell it, so you write an option. You expect the stock price to remain flat over the option’s duration. In exchange for granting the option buyer the right to buy your stock at the strike price (the price per share the option buyer must pay when she exercises her right to call away your stock), you’ve collected a premium.

If you’re right and the stock flatlines, you’ve pocketed the option premium and still own the stock. Wouldn’t it be wonderful if: a) you could always be assured that you were getting a good premium,

b) the stocks you wanted to hold were never called, and

c) whenever something went against you — you should have sold the stock because it declined in value subsequent to your decision to hold and write a call on it — the decline in the stock price didn’t exceed the option premium you received?

Stock prices don’t always move predictably, so as an option writer, you have plenty of opportunities to experience remorse. For instance, you sell a call option, but the stock rallies and the call-option buyer uses the contract to buy your stock at the lower price you agreed on earlier. You receive the option premium, but you would have been better off had you sold the stock at its higher price, as opposed to the strike price.

Or, you collect a premium, but the stock subsequently craters, leaving you with paper losses many times greater than the premium — and a stock without near-term prospects.

To minimize potential remorse, consider these factors:

Market volatility: When volatility is low, there are lower option premiums, and yield levels from option writing decline. Investors opt to be long in stocks and equity ETFs. The greater the volatility embedded within the option price, the higher the premium received. This varies from sector to sector and from company to company.

Underlying exposure: Covered-call writing can lessen the pain of holding an investment that gets hit hard, but only to a point. For instance, when both covered-call stocks and straight long stocks take big losses, a small outperformance by the covered-call stock is scant comfort.

Juiced-up premiums: Market volatility is dampened within a broad market index. By writing options on the stocks comprising the index instead of the index itself, you can collect option premiums that are 20% to 25% higher, says one portfolio manager. It’s further boosted by the ability to then repurchase (or “cover”) the call depending on its value and prospects. Then, when your want to, you can rewrite it using a different strike and expiration date.

Conflicting objectives: Investors are often attracted by the strategy’s high-yield potential, but you should resist the urge to spend the cash flows generated and instead take advantage of the compounding benefits of the strategy.