The Appeal of Covered Calls in Today’s Market
After years of soaring stock prices, equity valuations are reaching levels that have many advisors rethinking risk. One once-overlooked options strategy is suddenly drawing fresh attention, not as a bet against the market but as a way to stay invested while adding a layer of protection.
At this year’s Investments & Wealth Institute forum in New York, Jeff Bilsky, senior portfolio manager at Chartwell Investment Partners, showed how covered calls can curb volatility without sacrificing returns. Interest in the strategy was clear — the room was packed.
The appeal of covered calls lies in their ability to let investors protect against downside risk without severely limiting potential gains. Compared to traditional hedging strategies like buying put options, covered calls offer advantages such as earning money upfront rather than costing money.
Despite clients sometimes feeling uncomfortable with options, Bilsky emphasized that selling calls is different from buying them. In a covered call strategy, investors sell calls to hedge their portfolios and produce less volatility going forward.
How Covered Calls Work
In a covered call strategy, an investor who already owns shares of a stock sells call options on those shares. Selling the calls generates upfront income in the form of premiums, which can help cushion the portfolio if the stock dips. In return, the investor agrees to sell the shares at a set price — the option’s strike price — if the buyer chooses to exercise.
This approach provides a measure of downside protection while allowing the investor to stay invested, though it does limit gains if the stock climbs sharply above the strike price.
For example, imagine an investor owns 100 shares of a stock trading at $50 and sells call options with a $56 strike price, collecting $2.50 per share in premiums. If the stock stays below $56, they keep the $2.50 per share as extra income. If the stock rises above $56, they must sell at that price if the option purchaser so chooses.
The Downside to Downside Protection
While covered calls offer unique protection for investors, they also have the potential to hurt more than they help under certain circumstances. Covered calls have an asymmetric return profile, limiting potential gains while leaving the downside technically unlimited.
Temporary corrections can cause investors to lose money through a phenomenon called the “whiplash effect.” Even though the stock ends roughly flat, investors may see a net decline as a result of market fluctuations.
Knowing When to Use Covered Calls
Despite the risks, covered calls remain a compelling tool for advisors looking to add some protection in an unpredictable market. Covered call ETFs have drawn a surge of interest, reflecting the power of the strategy when conditions align.
While covered call funds may lag broader equity markets over longer periods, they can deliver strong performance when used selectively. Morningstar data highlights the importance of using covered calls strategically rather than as a one-size-fits-all replacement for traditional stock exposure.
