If you invest in stocks these days you're probably part of the 2% club. That's roughly the dividend yield of the S&P 500 (.SPX) – and it's well below the median yield of 4.4% for stocks, going back to 1871.
Yet there may be a way to earn a bit more income from stocks — without taking on additional risk: selling call options against stocks you own.
Selling call options may sound intimidating and risky. But it can actually reduce your stock risk and is one of the "most conservative strategies you can use," says Bridget Cunningham, a private portfolio manager with KeyBank, based in Syracuse, N.Y.
Indeed, some studies suggest the strategy — known as selling covered calls — can be a good way to dampen stock volatility, and may produce slightly higher returns over long periods.
Selling calls: The pros and cons
One 2006 study by research firm Callan Associates compared the returns of the S&P 500 with the CBOE S&P 500 BuyWrite Index (.BXM) — a covered-call benchmark index.
The study found that from June 1988 to September 2006 the BuyWrite index had two-thirds the volatility of the S&P 500 and generated a slightly higher average annual return: 11.77% versus 11.67% for the S&P 500.
The study didn't factor in trading costs and taxes, which would erode actual returns. And selling call options has some drawbacks — namely that you limit the upside potential in stocks.
Still, some advisers use the strategy in a bid to reduce volatility and boost income for their clients. In addition, some closed-end funds specialize in selling calls, offering distribution rates of roughly 9%, though that sometimes includes a return of capital.
Here's a rundown of the strategy as well as some funds you may want to investigate further.
How the strategy works
A call option is a contract that gives an investor the right to buy a stock at a certain price in the future, known as the strike price. The option has a cost, or "premium." The buyer of the call makes money if the stock rises above the strike price, plus the cost of the premium.
For example, suppose Apple (AAPL) is trading at $465 a share. An investor might purchase a call option to buy 100 shares of Apple at $500 by Oct. 4, when the option expires. The call option costs $$1.28 (or $128 for the right to buy 100 shares of Apple stock at the strike price of $500).
If by Oct. 4 Apple stock is at or below $501.28 (the stock price plus the premium), the call isn't profitable for the buyer and the option would expire worthless.
But the seller of the call — in this case, you, if you held enough Apple stock — would keep the stock plus the $128 from the sale of the option. You could then turn around and sell another option on the stock, pocketing an additional $128. And so on.
If Apple stock tops $501.28, the call becomes profitable and the buyer would exercise her option to buy the stock — "calling" it away from the option seller, who would forfeit gains above $501.28 and give up 100 shares of Apple.
Selling calls against your stocks
One way to use the strategy is to sell calls against stocks in your portfolio that you wouldn't mind giving up. The strategy is known as selling covered calls because you own the underlying stocks. It could be worthwhile if you have some stocks you don't think have much upside. It can also help offset losses if a stock declines.
Minneapolis financial adviser Stephen Dygos, for example, recently wanted to trim exposure to insurer AIG (AIG). Instead of selling his client's 400 shares outright, Dygos sold calls against 200 shares, earning a bit of income before trimming the position.
"It's a great way to make some extra money on a stock you would want to sell anyway," he says.
Overall, sharp swings in the market tend to help call sellers since option premiums tend to be worth more in a volatile market.
But call sellers can also benefit in a sideways market, when stocks barely budge. In that scenario, an investor could repeatedly sell calls on the same stock, adding a bit of income, even if the stock price stays relatively flat.
One standard approach is to sell calls against "high-quality" companies with volatile earnings, says Morningstar analyst Philip Guziec. If the company has a solid business, you limit your "downside risk," he explains. And call premiums tend to be higher for stocks with volatile earnings, offering more income for the seller of the option.
"You're getting paid cash today for some unknown upside potential in the stock," he says. "But there's still a risk that the stock will fall and you want to minimize that risk with a quality company."
Keep in mind that selling calls involves trading costs and can generate taxable income. Plus, since options are complicated, "you can get yourself in trouble very quickly," notes Dygos, the Minneapolis adviser.
'Buy write' closed-end funds
Several closed-end funds that use covered calls can be a good way for investors to tap the strategy. The funds are known as "buy write" funds because they buy stocks and then "write," or sell, calls against the stocks or indexes to generate income.
Bear in mind that closed-end funds have their own set of risks. They trade on the open market like stocks with prices that fluctuate between a discount or a premium to their underlying "net asset value."
Funds may also return investors' capital as part of their distributions, eroding their NAV over time. And they may distribute lots of ordinary income, making them best-suited to a non-taxable account like an IRA.
One way to reduce the risks is to buy these funds gradually over a period of weeks or months. Some financial advisers also recommend buying the funds only when they trade at a deep discount to their NAV.
Below are a few funds worth considering, based on past performance and suggestions by fund analysts. As always, you should do your own research or consult an adviser before investing.
Blackrock Enhanced Capital and Income Fund
- Ticker: CII
- Distribution rate: 9.2%
- Discount to NAV: -12.1%
- Expense ratio: 0.92%
A new management team took over this Blackrock fund last October in a bid to improve returns. The fund focuses on large-cap value stocks — companies like Google (GOOG), American International Group and Vodafone (VOD) — and sells calls against individual socks covering roughly half the $652 million fund.
Over the last five years, the fund beat 87% of rivals, according to Morningstar. The fund's expense ratio is below the category average, and while the fund has returned capital over the years, it generally hasn't been detrimental to the NAV, says Morningstar analyst Cara Esser.
One caveat: The new stock-picking team hasn't proven itself with the fund. Still, lead manager Tim Keefe racked up a strong record at his previous funds, says Esser, adding, "We have every reason to believe the fund has potential going forward."
The downside: The share price may diverge sharply from the S&P 500. It sank 6.8% in 2011, for instance, when the S&P gained 2.1%.
Eaton Vance Tax Managed Global Buy Write Opportunities Fund
- Ticker: ETW
- Distribution rate: 10.1%
- Discount to NAV: -9.3
- Expense ratio: 1.08%
The fund invests in global giants from Apple to Swiss drugmaker Roche (RHHBY). The managers sell calls against U.S. and foreign stock indexes rather than individual stocks, and the $1.3 billion fund pays a pre-set monthly distribution, currently 9.7 cents a share.
Overall, the fund's performance has been solid, with relatively low volatility, says Morningstar's Esser. Returns averaged 12.8% over the past five years, beating 66% of rivals. And the fund's board of directors has taken steps to narrow the fund's discount, helping to boost returns, she adds.
The downside: The fund has returned capital to maintain its distribution rate and manage taxes. If it relies heavily on returning capital in the future, the NAV could languish.
Nuveen Equity Premium Opportunity Fund
- Ticker: JSN
- Distribution rate: 9.1%
- Discount to NAV: -9%
- Expense ratio: 0.96%
This Nuveen fund aims to track an index of 75% S&P 500 stocks and 25% NASDAQ 100 (.NDX) stocks. Technology stocks figure prominently in the growth-oriented fund, accounting for 29% of its $900 million in assets, followed by healthcare stocks at around 12%. The managers sell calls against the indexes rather than individual stocks.
Overall, returns averaged 9.6% over the last five years, versus a 10.5% average return for the S&P 500. The fund's returns trailed the market due to the call-writing strategy, says Esser, which limits potential gains.
But performance looks stronger on a risk-adjusted basis, she says, and the management team at Gateway Asset Management, the fund's adviser, has built a strong record. The fund's expense ratio is below the category average, she adds, and its turnover is low, keeping costs down.
The downside: The fund has a managed distribution policy — paying a set amount each quarter — and it has returned capital to meet its distribution targets, pressuring the NAV. If the trend continues, it could keep the NAV down.
Pam Black is a freelance contributor and Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. They do not own any of the securities mentioned in this article.