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The Search for Income: Covered-Call Funds

Equity investors looking for added income may want to consider covered-call CEFs. 

Cara Esser, 06/08/2012

In the never-ending search for income, equity investors often boost income-generation potential by way of derivatives. In the context of fund investing, a popular strategy for equity closed-end funds, or CEFs, to boost income is to sell call options on the underlying portfolio. This strategy goes by many names (covered call, buy-write, and option overlay to name a few) and is wide-ranging in its implementation.

I often read Morningstar.com's CEF Discussion Boards to gain a sense of what is top of mind for our readers, and covered-call CEFs are often a hot, and divisive, topic. Some believe these funds are great at generating additional income on top of equity strategies that are often low-income-generating, while others think less highly of the strategy. And, as the CEF analyst covering these buy-write funds, I've received many questions about how they work and if they are right for an investor's portfolio. While I can't assert whether a specific fund is right for any investor's individual portfolio (those decisions are complex and should be considered on an individual basis), I can provide a primer on the ins and outs of these funds.

The Basics
Let's start from square one. Call options provide the buyer with the right--but not the obligation--to purchase a security at a specified price (strike price) at some point in the future (prior to the expiration date). For this option, the buyer pays the seller (or writer) a fee (option premium). In the context of a covered-call CEF, the fund is the call writer, or seller. Once a call option is written, the fund is obligated to sell the asset at the specified price should the buyer choose to exercise the option, or to buy back the call prior to it being exercised. In short, writing call options means the writer is selling some of the security's future upside potential to earn the option premium up-front.

Option premiums are priced based on implied volatility: If investors think the market will be highly volatile, an option will be priced higher. In times of extreme volatility, option prices can skyrocket, and covered-call CEFs can benefit from earning large option premiums. Historically, implied volatility has been higher than realized volatility, which means call writers have been generally overcompensated for the risks of writing call options. (On the flip side, this means that buyers have historically been overpaying for these options from a realized risk/reward perspective.)

Time to expiration and the "moniness" of the call option affect the premium as well. First, the longer the time to expiration, generally the higher the premium. "Moniness" refers to the relationship between the strike price and the underlying asset's market price. Options can be written in, out, or at the money. In-the-money options earn the highest premium because, assuming no option cost, they are exercisable immediately. Accounting for the option premium, the option won't be exercised until the difference in strike price and asset price exceeds the premium paid. Out-of-the-money calls are priced based on how far out of the money they are, with a higher premium being paid for a strike price that is closer to the asset's market price. At-the-money options are written with strike prices equal to the current asset price (these also won't be exercised until the difference between strike and exercise prices is greater than the premium). Most CEFs write calls that are at the money or slightly out of the money (typically 1% to 3%, but some write calls more than 5% out of the money) and most are short-term in nature (30-90 days, but shorter-term options are also used).

As an extremely simplified example of how a call option works, let's say a fund writes one call option on a single share of ABC stock for $10, expiring in 30 days. The stock is currently selling at $9, so the call option is 11% out of the money (11% being the increase that a $9 stock has to enjoy before hitting $10). The fund receives $0.10 in option premium because in this example the call option is worth only $0.10. The fund will keep any gains from share price appreciation from $9 to $10.10 (again, the buyer won't exercise the option unless it provides a gain over the price paid, which in this case, is $0.10), plus it keeps the call premium. Should the stock appreciate past $10.10 in 30 days, the fund misses out on any of those gains above $10.10. Because of this, in a quickly and steadily rising market, a fund writing call options will tend to underperform a similarly invested fund that does not write call options.

On the flip side, in a steadily declining market, the fund will pocket call premiums because options generally won't be exercised, but its underlying portfolio will be declining in value with the market. The call premiums help soften the blow, allowing the fund to outperform similarly invested funds in down markets.

Single Stock vs. Index Options
Of the 31 closed-end funds employing covered-call strategies (Morningstar categorize funds as "covered call" if they overwrite at least 50% of the portfolio's notional value), there is a good mix between those employing single stock and index strategies. Note that there are a number of funds employing a call-writing strategy on less than 50% of the portfolio.

Cara Esser is a closed-end fund analyst at Morningstar.
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