A cash cow in a bear market?

Dale Anderson, a retired car dealer in Muncie, Pa., used to sell dreams with names like Buick, Mitsubishi and Saab. Now at 75, he's living the dream, working a few hours a day at home, earning 15% to 20% a year investing in the stock market.

Few investors can call the market a dream machine these days, with equities down a brutal 40% from a year ago, but Anderson says even last year, he "eked out" an 18% gain—a return investors would envy in the best of times. His secret: covered calls. "It sure beats selling cars!" he says.

Covered calls, the practice of selling call options on stocks that an investor already owns, or of selling calls at the same time as buying the underlying stock (a process called "buy/write"), are an increasingly popular strategy for earning profits in a prolonged bear market. "Covered calls are a good income strategy in a down market, where you don't often end up having to sell the stock because it doesn't rise to the strike price of the call," says James Abbott, a financial advisor at Two Rivers Bank and Trust in Burlington, Iowa. "We've been using them in retirement portfolios especially, where you don't have to worry about the tax consequences if calls are exercised."

Rising Premiums

Huntington Bank's asset management group has been using covered calls since last Thanksgiving, says senior portfolio manager Peter Sorrentino. "Since then, fear has been giving way to greed again, with some people beginning to believe there could be some upturns." Investors once again believe that certain major stocks will spring back to life, and fearing that they will miss out on that appreciation, are willing to pay a higher premium for such calls on those stocks. It's those premiums that can give the covered-call seller an income. "We've been writing calls out one month for several months now, and getting 1% returns per month on our stock portfolio, which is pretty good in this market," he says. Most of those calls haven't been exercised, so Sorrentino can keep selling new calls on the underlying stock each month. His picks are mostly energy and commodities companies, such as Apache Oil, XTO Energy, Potash Corp. and Rio Tinto, and some blue chips like P&G, Kroger and GE.

Ron Groenke, a former software company executive who took a buyout and became an investment advisor in Marco Island, Fla., has written books and run seminars touting covered calls. If you select relatively stable stocks, this can be close to a risk-free way to create a positive income stream on a stock portfolio, he says. "The key is the 'covered' part. If you own the stock, you're not leveraged, so there is a limit to how much you can lose if the stock drops. Your only real risk is an opportunity cost if the stock rises beyond the strike price of the call." Then, the call buyer would take possession of the stock, but not until you (the seller) had received the appreciation up to the strike price as well as the premium.

Groenke gives this example: "I buy GE at $12.09. If I buy 100 shares (options contracts come in 100 share blocks), and then sell a call at a strike price of $12.50 with a two-month strike date, I get $1.07 for that option per share. That's a $107 immediate gain on a $1,209 investment. If the shares rise past the $12.50 level before the strike date, the holder of the call will buy the stock at $12.50 a share, giving the call seller an added 41 cents per share gain for a total gain of $148. If the stock doesn't reach $12.50, the call will expire, and you simply pocket the $107 premium. "If the stock falls, you have downside protection of $1.07 a share," says Groenke. If a stock starts to tank and the owner wants out, he can buy back the call and sell the underlying stock. "Buying back a call is usually a lot cheaper than the original sale price of the option," says Groenke, "so you get to keep part of the initial premium."

Groenke writes calls only on "good solid companies," large-cap firms in the S&P 500 or Fortune 500-"companies that you know will be around like GE, Microsoft, Intel, Cysco, Caterpillar, Boeing." He steers clear of companies with a market cap of less than $500 million. "I also look for positive revenue growth, ideally 10% to 15% per year, positive earnings for at least three of the last four quarters and positive bare cash (cash plus marketable securities less long-term debt)." He then narrows his choices to companies that aren't trading near their highs (no problem these days!). His stocks share a low probability of plunging and command a relatively high call premium from investors who are willing to bet these stocks will beat the strike price.

James Knight, vice president of the options department at Raymond James, says four types of stocks are suitable for covered-call plays: "dogs," blue chips, growth and aggressive growth stocks. He rejects three of the four: dogs have too much downside risk; blue chips generally carry lower call premiums; and aggressive stocks could soar, causing a loss on the upside. But growth stocks "carry better premiums and have less downside risk," he says.

Income Drivers

An advisor at an Arizona-based bank who asked to remain unidentified, says, "I've been running a strategy of covered calls for some time. We try to earn 3% to 5% a month that way for people's portfolios. On an annualized basis, we look for an 11% to 15% return, or even 20%." He sees the strategy as an "add-on, income-producing" part of a portfolio. He places covered calls on 20% of a client's portfolio.

The Internal Revenue Service has approved covered calls for use in IRA and 401(k) funds because the underlying principal is not put at risk as it would be with an "uncovered" call option. Still, only a few banks have approved the strategy for advisors. "Maybe one in five brokers do options strategies, and at banks it's even lower," says Knight. "I think far more banks should be including covered calls in their list of approved investment strategies. This strategy is like having the client be the guy with the roulette wheel instead of the guy making bets on the wheel."

However, bank investment policy committees are slow to approve covered call writing because "people hear options and think risk and complexity," says Knight. Also keeping track of exercised calls and strike dates, which occur on the third Friday of each month, is "extra work for the broker-dealer." That said, the process of selling calls is quite simple: Any broker who handles stock orders can also sell calls and handle the transaction if a call is exercised. Most brokers should also have no problem handling buy/write orders. Discount brokers are best for this strategy, since it involves active trading.

For tax purposes, the premium is considered income, but if a call is exercised because it has appreciated above the strike price, that gain is taxed at the capital gains rate. If the stock declined and was sold, the capital gains loss could be counted against the income from the call premium. None of this applies if used in an IRA, which makes tax-deferred portfolios ideal for this kind of active trading strategy.

In today's market, "when everything is going down and the calls don't get exercised, we just keep writing new calls on a stock each month, and earning the premiums as it declines," says the Arizona bank rep. But Knight says that covered calls are more like fixed income. "A lot of people invest in stocks for a home run," he says. "But you want to avoid triple plays and try to get hits, and covered calls are a way to accomplish both." Still, winning on singles requires skill, perseverance and teamwork. "Covered calls are not for everybody," cautions Two Rivers' Abbott. "But for financial advisors who can offer this strategy, it is a way they can add value to the equation."