Covered call strategies in a closed-end fund may help long-term investors manage short-term volatility.
Successful investing is not just about reaching the final destination; the journey itself can be equally important. Equity investors in particular need to account for the likelihood of volatility along the way and seek strategies for limiting loss while staying in the market.
The impact of steep losses on long-term returns can be significant, as the chart below shows. Investors may want to consider lower volatility strategies, such as those used by equity covered call closed-end funds (“CEFs”), which can help to manage portfolio risk and potentially produce a better risk-adjusted outcome.
What are covered calls?
Insurance markets allow purchasers to protect against uncertain events and risks. For instance, automobile insurance protects car owners in the unfortunate event of an accident in exchange for a premium. Option markets work in a similar fashion. (An option is a contract that gives an investor the right, but not the obligation, to buy a security at a later date at an agreed-upon price.)
Investors who want to protect their portfolios from volatility or other uncertain outcomes can sell, or “write,” options on their current stock holdings. The seller receives an upfront “option premium” these premiums generate cash flows, which can help to offset some of the downside risk of owning the underlying stock. In exchange, the option writer (or seller) is obligated to sell the underlying equity security at the call’s strike price if the buyer chooses to exercise the option. As a result, upside participation potential is limited by the strike price plus the initial premium. By using an equity covered call strategy, investors may reduce portfolio volatility by capturing option premiums, potentially enhancing risk-adjusted returns.