Is selling covered calls considered a high risk strategy to generate retirement income?
I am looking to increase my overall retirement savings. I have a company 401(k), but also own a Roth IRA that I would like to invest more aggressively. Would you consider selling covered calls too risky because it could jeopardize my funds?
Generally, selling a cover call is considered to be one of the option strategies with the least amount of risk since you already own the shares. Your main risk is that you are capping the unlimited upside potential to your stock and that your shares might be called away from you at the given strike price that you sold.
It's also important to note that many brokerage firms will only allow for covered call strategies in retirement accounts.
Best of Luck!
Done properly, a disciplined covered call strategy can make a lot of sense in a tax qualified account like an IRA or ROTH. If you buy stocks that you don't mind holding for the long run, let them appreciate and then sell out-of-the-money calls against them, you will create income from the sale of the call premium and, because you've sold an option at a strike price above both the current price and above the price you paid, if the stock is called, you'll sell it at a profit. If the price of the stock declines after you sell the call and remains below the strike price until expiration, you keep the stock, keep the premium, and you can repeat the process. While this strategy is considered risky because it requires the purchase of individual stocks and involves relatively active trading, the potential to lose money (which is what most investors are worried about when they consider risk) is no higher than an individual equity buy and hold strategy.
The short answer is "probably not," but this depends on several factors. I'll share those factors, my background, and information on related indices for past performance. There are also tax considerations IF using a taxable account. But you said this would be for a ROTH IRA.
I was an equity options market maker for 9 years both on exchange floors and on trading desks. In our RIA practice, we do offer a call selling hedge.
WARNING: options are complicated, I strongly encourage you to learn about them and do mock/paper trading first before actually trading.
The strategy you describe is the most common options strategy and it's a bullish strategy. It's also called a buy-write, buy stock-write calls (sell calls). Most options can control 100 shares of their 'underlying' so a 1-to-1 hedge is long 100 shares and short 1 call.
The Chicago Board of Exchange, CBOE, has several indices with back-tested performance. Check them out at this link:
The BXY has far outperformed the S&P 500 over the last 10 years (and probably 20 years) WITH less risk as defined by volatility represented by standard deviation, the holy grail right? Outperformance and lower risk. There is something called 'pin risk' to look into when the stock gets pinned to the strike price at the option expiration date. There is also 'friction' or fees involved with trading that will lower returns vs. the theoretical index performance. This strategy, executed correctly, is a LOWER risk strategy than a naked long position.
Covered call writing is a strategy that tends to lower risk rather than increasing risk. Typically, in such a strategy, income is generated by selling a call ( known as writing a call) for every 100 shares of stock.
It sounds great, receiving these premiums from "unwitting" speculators who are gambling on short-term price movement. But there are negatives as well.
In a rising market, such a strategy tends to lower your returns. You effectively put a ceiling on the upside in the underlying stock. This can harm long-term returns despite receiving the additional income of call writing. In a falling market, there is still downside in the portfolio. In a falling market, you do capture the extra income from written calls as they expire worthless to the buyer, BUT you are still exposed to equity risk in the portfolio as stocks fall. The premiums may not cover the losses of the falling portfolio.
Writing calls tends to reduce riskiness of a portfolio by lowering the volatility. But it may also truncate, or limit your returns if you are not adequately compensated for writing these calls. This can occur if you write calls during periods of low volatility (i.e. the stock feels like its going nowhere). That's where the potential for jeopardizing your portfolio may arise. You may fail to achieve the equity returns that an uncovered strategy would have provided.
I hope this addresses your excellent question.
Writing covered calls is considered one of the more conservative options strategies, however, the potential downside is still significant. The strategy consists of receiving a call premium (i.e. income), meanwhile giving up substantial profits. If the stock price rises sharply, your shares must be given up, and you do not participate in the upside. If the stock price declines sharply, you will suffer significant losses (because you are still holding the underlying shares). The Options Industry Council provides a thorough description of the strategy.
This strategy could should be evaluated within the context of your entire retirement portfolio. One example is if the equity portion of your retirement portfolio consists of 10 individual stocks (on which you are writing calls), several issues become apparent. The equity portion of the portfolio is not diversified; a fully diversified portfolio of stocks consists of many companies spread among various sectors, geographies, and market capitalizations (very difficult to do with 10 stocks). Also, if the group of stocks does exceptionally well during the option period, you will be forced to give up the shares.
The strategy may make sense in certain situations, however, I strongly recommend fully understanding all of the risks. I hope this helps.
Chris Cyndecki, CFP®