What is a covered call?

During down or flat markets, covered-call products tend to gain in popularity. Assets in options-based ETFs grew by $4.4 billion last year, according to National Bank, with covered-call strategies making up the majority.

The reason for the increase? Covered-call strategies work well in periods of market volatility, said Chris Heakes, director, portfolio manager of equity, derivatives-based and multi-asset portfolios at BMO Global Asset Management.

“Covered calls make [volatility] work for investors because they can get more premium or more attractive options trades with it,” he said.

Here’s how the strategy works.

“A covered-call fund essentially invests in a basket of underlying securities and writes call options on that basket of stocks,” said Jaron Liu, director, ETF strategy at CI Global Asset Management.

There are funds in Canada using covered calls on broad market indexes as well as on companies within specific sectors such as banking and energy.

“A call option is a contract that gives the buyer the right, but not necessarily the obligation, to buy a stock at some predetermined price,” Liu said. “In exchange, the seller of that option receives an option premium. Investors can generate higher income from those option premiums.”

If the market is down or flat, Liu said, a covered-call strategy can potentially outperform a similar strategy that doesn’t have call options written on it because “those option premiums that the seller gets provide additional income and can help offset some of the stocks’ decline.”

For instance, let’s say a basket of securities is trading at $115. The manager writes a covered-call option for someone to buy those securities in a month at $120 with a $1 option premium. If the value of the basket of securities declines or stays the same, the buyer decides not to exercise their option and the seller keeps the securities and the premium. For the options seller, the decline in the portfolio’s value is partly cushioned by the premium.

In exchange for these benefits, investors give up the potential for upside if stocks rally. 

“When there’s strong upward movement in stocks, that increases the likelihood that the call options end up in the money, which means that the underlying stocks will be called away,” Liu said. “So investors lose out on some of that growth potential.”

Let’s return to our example of a basket of securities trading at $115. If the basket goes up to $123, the options seller only nets the $120 strike price plus the $1 premium, leaving the rest of the gains on the table.

“So the further the strike price is written from the actual stock price can affect the yield and the performance of these strategies,” Liu said.

Aside from the ability to generate potentially higher income than the market, covered calls are also tax efficient, Heakes said. That’s because the income from option premiums is taxed as capital gains (50% taxable) rather than interest (100% taxable).

Finally, it’s important that investors understand the underlying investments within the covered-call strategy, as well as what percentage of the portfolio has call options.

“It could be 25%, 33%, 50% or more,” said Vernon Roberts, options strategist at Horizons ETFs Management (Canada) Inc. “This way, investors know how much of the upside they’re actually participating in, as well as the risk of the underlying assets so that they are comfortable.”

Writing calls on a smaller percentage of holdings allows more room for upside, while writing covered calls on 100% of a portfolio would eliminate all potential upside.