Covered Call Funds

covered-call strategies tend to lead in sideways and down markets, but lag in strong bull markets.

By: Martin Lees

Narrated by: Virtual Voice

These funds earn extra income by selling call options on the stocks in their portfolios. Call options give the buyer the right to purchase a stock at a set price within a certain time period. Here’s how it works: Imagine a fund owns shares of ABC, which currently trades for $50. The fund might sell a call option that gives the buyer the right to buy ABC shares for $60, within one month. And suppose the fund earns $2 per share in income for selling the option. If ABC shares rise to $65 during that month, the buyer will exercise his or her option and the fund will hand over its ABC shares, having earned $12 per share instead of $15. If the stock instead falls to $40, the option will expire unexercised and the fund will have lost just $8 per share, rather than $10. And if the stock price ho-hums along to $51, the fund nets $3 per share in profits. As that math illustrates, covered-call strategies tend to lead in sideways and down markets, but lag in strong bull markets. Because the price of options rises when market volatility increases, market chop also tends to boost the funds’ returns. So, if the market continues on its jagged sideways course, covered-call funds could shine.