With the Fed signaling that interest rates will continue to be non-existent until 2014, the hunt for higher-yielding income solutions continues. Dividend-focused ETFs like the SPDR S&P Dividend (ARCA:SDY) have surged in popularity and more investors have added "exotic" alternatives like master limited partnerships (MLPs) and junk bonds to satisfy their need for higher income.
One potential income play that is overlooked by many portfolios is various covered call options strategies. While investors may be hesitant about writing options themselves, there are plenty of funds that make it possible to add the strategy. These funds can add extra yield and reduce overall volatility. For investors, that could be exactly what the doctor ordered for the low interest rate environment. (For related reading, see Options Basics.)
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A Simple Strategy
Options strategies have often been the realm of day traders, high net-worth individuals and institutions, and are often ignored by the retail investor space. However, for those seeking to expand their portfolio's income potential, a buy-write options approach may be in order. At its very basic, a buy-write or covered call is an investment approach where the investor buys a stock or a basket of stocks tied to an index and writes call options that cover the stock position.
A call option gives its holder the right to buy a stock from the option seller at a certain price by a certain date. By writing the call, an investor caps the upside potential of the underlying stock, put generates income from the fee the option buyer pays. With interest rates continuing to hover next to zero, these call writing strategies offer big income potential.
Another reason to be bullish on covered calls: a sideways drifting market. Volatility remains an issue as the market reacts and overreacts to each day's news feed. Europe's debt problems, slowing growth in China and the United States' political gridlock have helped the S&P 500 essentially finish flat for 2011. However, during that time the indices had huge price swings both upwards and downwards.
During this flat market, The Chicago Board Options Exchange's BuyWrite Index (BXM), which is gold standard for covered calls, rose 5.7% during the year. With a variety of analysts expecting a repeat of 2011's volatile sideways market for this year, investors can expect buy-write strategies to outperform again. (For more information, check out The Basics Of Covered Calls.)
Finding a Fund
For investors, selling covered calls offers great way to add income and potentially smooth-out 2012's predicted volatility. While investors can certainly write their own options, using a fund eliminates the lengthy research required and potentially could lead to higher income. The PowerShares S&P 500 BuyWrite ETF (ARCA:PBP) is based on the previously mentioned CBOE S&P 500 BuyWrite Index.
The ETF will generally invest at least 80% of its total assets in common stocks included in the S&P 500 and then will write call options on those positions. Those options have generated some significant dividends in 2011, with the funds current yield at over 10%.
Some of the most lucrative dividends in covered call funds can be found in closed-end funds. Currently, more than 30 closed-end funds offer this strategy. Many with distribution yield within the 8 to 16% range. The Morningstar bronze-rated BlackRock Enhanced Dividend Achievers Trust (NYSE:BDJ) could be great place to start. The fund owns a portfolio of blue chips like Chevron (NYSE:CVX) and Deere (NYSE:DE), and then writes call options on more than half of that portfolio.
As of this writing, the closed-end fund can be had at a 9.15% discount to its net asset value and yields 8.97%. Investors looking for a more global approach should try Cohen & Steers Global Income Builder (NYSE:INB). The fund is roughly split between U.S. and international firms and uses leverage to "juice" its covered call income. Shares of the fund trade at a slight discount and yield over 12%.
The Bottom Line
Given the expected volatility and continued low interest rates, investors looking for more income might want to add a covered call strategy to a portfolio. Offering both high yields and sideways market protection, these funds could be exactly what investors need for the upcoming year. The previously mentioned funds, along with the ING Global Equity Dividend & Premium Opportunity Fund (NYSE:IGD) make interesting choices. (To learn more on ETFs, check out Advantages And Disadvantages Of ETFs.)
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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.