By Omanand Karmalkar, CFA, BMO ETFs
The need for income from investments has become more important than ever given an aging population, higher inflation, and cost of living. There are many ways to earn income from investments, but two distinct pathways emerge: the well-trodden path of traditional income and the emerging use of covered call strategies. Let’s dive a bit deeper into the two methods.
Covered Call Strategy: A Paradigm Shift in Income Generation
The covered call strategy is an investment strategy that involves the purchase of an underlying asset, such as a stock, and the sale of a call option on that same asset. By selling the call option, the investor agrees to sell the underlying asset at the strike price of the option if the option is exercised. Essentially, they involve holding a portfolio of stocks while simultaneously selling call options on those holdings. This approach creates a dual stream of income: dividends from the underlying stocks and premiums collected from the sale of call options.
- Balancing Act: Income vs. Capital Appreciation
The allure of the covered call strategy lies in its potential to provide a higher yield compared to traditional income investments. Furthermore, the yield generated by writing call options is taxed more preferably under capital gains accounts while interest income from fixed-income products (such as GICs) is taxed under income.
Traditional Income Investments: The Time-Tested Approach
- Classic Income Investments
By contrast, traditional income investments have been around for a very long time and can be reliable sources of income. This category includes bonds, GICs, and dividend-paying stocks. Bonds provide regular interest payments, GICs [Guaranteed Income Certificates] offer fixed interest rates, and dividend stocks distribute periodic income.
Stability and Predictability
The hallmark of traditional income investments is their stability. Bond interest payments, GICs, and dividend distributions are relatively predictable. This predictability appeals to investors who prioritize a steady income stream and wish to avoid the potentially higher volatility associated with other investment options.
Comparing Covered Call Strategies and Traditional Income Investments
Covered Call strategies typically offer a higher yield due to the combination of dividends and option premiums. This can be especially attractive for income-focused investors seeking higher returns. By contrast, traditional income investments tend to provide more modest but steady income streams.
Risk and Upside Potential
The risk profiles of these two approaches differ significantly. Covered Call strategies come with a form of built-in risk management due to the sale of call options, which helps mitigate losses during market downturns. However, this strategy also limits potential gains. Traditional income investments come with their own risks, such as interest rate fluctuations affecting bond prices.
Market conditions play a crucial role in the performance of these two options. Covered Call strategies tend to shine in stable or mildly bullish markets, where consistent option premiums can be collected. Traditional income investments, on the other hand, can offer reliable income regardless of market conditions, making them resilient during periods of market volatility.
Income-seeking investors have a comprehensive and vast landscape of investment possibilities available to them. Both strategies offer a wide array of benefits and drawbacks and depending on the goals and preferences, one can create an income focused portfolio that can benefit from using covered call strategies, traditional income investments or both.
Omanand Karmalkar, CFA, is a Vice President and Portfolio Manager with BMO Exchange Traded Funds, focusing on equity, derivatives-based and multi-asset portfolios. Prior to joining BMO Asset Management Inc., Omanand was a Portfolio Manager at TD Asset Management on the Asset Allocation team, where he provided ongoing risk management and tactical/strategic portfolio design of fund-of-fund solutions. He also helped develop new innovative solutions and manage option strategies. He holds a Bachelor of Mathematics from the University of Waterloo and is a CFA Charterholder.
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