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As part of our Master of Science in Financial Analysis program we offer a course titled FINA585 Derivatives and Alternative Investments. Among other topics the course covers alternative investment strategies using derivatives. One popular strategy that we cover is covered calls (no pun intended).

This post explores how covered calls work, how you can implement them directly or through professionally managed funds, and—most importantly—under what market conditions they’re most effective.

What Is a Covered Call Strategy?

A covered call involves two components:

1. You own a stock or portfolio of stocks, and
2. You sell (or “write”) a call option on that holding.

The option gives another investor the right—but not the obligation—to buy your stock at a fixed price (called the strike price) within a specific time. In return, you collect a premium, which becomes income for you.

If the stock rises above the strike price, your gains are capped—you may have to sell the stock at the strike price. If the stock stays below that level, you keep both the stock and the premium.

How to Implement a Covered Call Strategy

There are two common ways to implement this strategy:

1. Writing Calls on Individual Stocks

If you hold at least 100 shares of a particular stock (since one options contract typically covers 100 shares), you can write a call option against that position. For example, if you own shares of a large-cap technology company trading at $100, you could sell a one-month call option with a $105 strike and collect a premium. If the stock stays below $105, you retain the shares and the premium. If it goes above, your upside is capped, but you still retain the premium.

2. Using a Professionally Managed Covered Call Fund

For investors and advisors who prefer a hands-off approach or want built-in diversification, there are professionally managed funds that implement covered call strategies across entire indexes or baskets of stocks. These funds regularly write call options against their holdings and distribute the collected premiums as income.

These vehicles are popular for income-focused investors because they often produce significantly higher yields than traditional stock funds. But it’s important to understand the source of that yield—it comes by sacrificing a portion of the portfolio’s upside potential.

There are many ETFs and mutual funds offering covered call strategies to chose from.

Why Use Covered Calls?

The primary advantage of a covered call strategy is that it can enhance income, especially in flat or volatile markets. The option premiums provide a steady stream of cash that can buffer modest market declines or sideways movement. Research has shown that these strategies reduce portfolio volatility by as much as one-third.

Historically, covered call strategies have delivered:

• Lower volatility than pure equity portfolios
• Reduced drawdowns during market corrections
• Steady income in the form of premiums collected

However, there is a cost: in strong bull markets, the strategy typically lags behind because the call options limit participation in upside gains.

When Is a Covered Call Strategy Most Effective?

This strategy performs best in the following market environments:

✅ Flat or range-bound markets: When stocks are trading sideways, call premiums provide income while the stock value remains stable.

✅ High volatility conditions: The more volatile the market, the higher the premiums collected—since option prices rise with implied volatility.

✅ Mildly bearish outlooks: Covered calls can soften the blow of modest declines by generating income that offsets losses.

✅ For income-focused investors: If you're prioritizing cash flow over growth—such as in retirement—this strategy can supplement or replace traditional dividends.

It is least effective when:

🚫 Markets are rising rapidly: You may be forced to sell your shares at the strike price, missing out on potential upside gains.

🚫 You want long-term capital appreciation: Covered calls work against the compounding effects of growth by repeatedly capping returns.

🚫 Taxes are a concern: Premium income is often taxed as ordinary income or short-term gains, making it less tax-efficient than holding long-term stocks or ETFs. This strategy works best in tax deferred or tax exempt accounts.

Key Considerations

Covered call strategies are not about beating the market, but about adjusting the return profile to better suit certain investment goals. They trade some growth potential for current income and lower volatility.

This makes them especially appealing to:

• Investors nearing or in retirement
• Those seeking predictable income from equities
• Investors with a neutral or mildly bearish outlook on the market

On the other hand, for younger investors or those seeking long-term capital growth, a buy-and-hold equity strategy may be more appropriate.

Final Thoughts

Covered calls can play a valuable role in a diversified portfolio—but only if used thoughtfully. While they won’t outperform in a bull market, they can help smooth out volatility, generate income in sideways markets, and reduce portfolio risk during downturns.