Stock markets continue to experience volatility amidst concerns about recession, Fed policy, and election uncertainty. Investors are seeking ways to protect their portfolios and potentially generate income. Covered call selling offers a valuable tool for managing risk and potentially enhancing returns.

What are covered calls?

A covered call involves owning a stock (or portfolio of stocks) and selling call options against it. The option seller receives cash, called a premium, in return for agreeing to limit gains or sell stock at a predetermined price, known as the strike price. The seller keeps the premium regardless of whether the stock goes up, down, or remains the same.

Benefits of covered calls:

• Reduce volatility: Covered calls can help mitigate the impact of stock declines by providing a cushion in the form of option premiums.
• Income generation: Selling call options generates cash through option premiums received. This income is especially valuable during periods of low or negative stock appreciation.

Trade-offs:

• Limited upside potential: Call sellers sacrifice significant upside capital appreciation potential, in return for cash up front. If the stock price rises above the strike price, the seller may be obligated to sell at a less favorable price.
• Risk of loss: While call selling can provide some downside protection, it does not eliminate risk entirely. If the underlining stock or index price drops significantly, the options premium may not fully offset the loss.

Performance in different market scenarios:

• Sideways markets: Covered calls tend to outperform in flat or slightly bullish markets, which can occur during periods of uncertainty and volatility.
• Sharp declines: While covered calls don’t fully protect against significant market drops, they tend to outperform simply holding stocks during bearish periods due to the income generated from option premiums.
• Rapid rallies: Covered calls may underperform during strong bull markets as they cap upside potential. However, the increased volatility during such periods can lead to higher option premiums for future trades.

Covered calls are a valuable tool for investors who anticipate a market drop but are unwilling to sell shares immediately. By generating income and potentially reducing portfolio risk, covered calls can be an effective risk management tool.

Final thoughts

While covered call strategies don’t provide complete protection against market volatility, they can seek enhanced income, some downside protection, and lower overall portfolio volatility. These characteristics make them an attractive option for investors looking to navigate turbulent market conditions while still maintaining exposure to equities.

To learn more about covered calls and how the strategy might help you achieve your financial objectives, contact your Signet advisor.

IMPORTANT DISCLOSURE

This is a publication of Signet Financial Management, LLC.

The information presented is believed to be factual, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Information in this presentation does not involve the rendering of personalized investment advice. It is limited to the dissemination of general information on products and services. A professional adviser should be consulted before implementing any of the options presented.

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