Wei Woo from Capital Research has been doing presentations here at our centre for over 7 years. Each month, he provides us with guest blog posts to educate us on a variety of financial topics. This month, he tells us all about Covered Calls. Make sure to watch our WSAC calendar to see when Wei will be in the centre doing his Toonie Talk presentations…we promise you won’t be disappointed.
READ HIS BLOG BELOW
Building from the previous article on how covered call strategies have become very popular for enhanced retirement income generation, let’s discuss the other side of the same coin, a covered put strategy.
A covered put strategy involves two main components: owning a position in a stock and simultaneously writing (selling) a put option on that same stock. This strategy is often used by investors seeking income or downside protection for their existing stock positions. Let’s explore how covered put strategies may enhance retirement income:
1. Income Generation:
a. Premium Income: By selling a put option, you receive a premium from the option buyer. This premium provides immediate income, which can be especially beneficial for retirees looking to supplement their retirement income.
b. Regular Cash Flow: The strategy allows investors to generate cash flow on a regular basis as long as they continue selling put options.
2. Downside Protection:
a. Reduced Cost Basis: The premium received from selling the put option can be used to offset the cost basis of the underlying stock. This effectively lowers the breakeven point for the investor.
b. Limited Downside Risk: The strategy provides a limited amount of downside protection because the premium received from selling the put option partially offsets potential losses in the value of the underlying security.
3. Enhanced Portfolio Yield:
Yield Enhancement: By incorporating covered puts into a portfolio, investors may enhance the overall yield ( investment income) . This is particularly valuable for retirees who rely on their investment portfolio for income during retirement.
4. Managing Volatility:
Volatility Buffer: Selling puts can help manage the impact of market volatility. The premium received can act as a buffer against short-term market fluctuations.
5. Stock Purchase at a Discount:
Potential Stock Acquisition: If the put option is exercised, the investor is obligated to buy the underlying stock at the strike price. This can be an opportunity to acquire more of the stock at a lower price, especially if the investor is bullish on the long-term prospects of the security.
This is opposed to a covered call strategy we previously discussed, in which the covered call option sold by the investor to generate investment income, can be used to force the investor to sell the stock they already own to the buyer of the call option ( if the market price of stock is above the agreed upon price between investor and buyer ) .
It’s important to note that while covered put strategies can provide income and some downside protection, they also have risks. If the stock price falls significantly, the strategy may not fully mitigate losses, and the investor could be forced to purchase more shares at a higher price than the current market value. For the average investor to put these strategies to work, it is most simple to do it through a mutual fund or ETF, compared to doing it with individual stocks.
Investors considering covered put strategies, especially in a retirement portfolio, should carefully evaluate their risk tolerance, market outlook, and the specific stocks or securities involved. It’s advisable to consult with a financial advisor to ensure that the strategy aligns with the investor’s overall financial goals and risk profile.
To revisit Wei Woo’s previous blog post? Click HERE.
