Covered Call Strategy for a Stable Income Portfolio

Constructing a stable income portfolio can be pretty challenging in an environment of low interest rates. Options that guarantee capital preservation such as bank fixed deposits, treasury bonds and bills (assuming it is held to maturity) provide comparatively little income. Holding defensive dividend paying stocks is a strategy that many investors use. The option is somewhat risky in that capital preservation is not guaranteed and it is rare that such a portfolio can produce income over 4%. A variation on the same theme is using covered calls to produce more income while sacrificing some of the capital appreciation potential. This approach guarantees more income but capital preservation is still a problem. Capital preservation can be achieved by purchasing puts against the long positions but that will obviously reduce income.

We are in a similar dilemma currently as we attempt to diversify away from a significant stock position held in an Employee Stock Purchase Plan (ESPP). Basically, the idea is to preserve capital while generating as much income as possible to support part of our on-going cash needs. To that end, we are in the process of building a defensive portfolio with good income generation. Below are a set of steps we are following to implement the strategy:

1. Build a core set of 20 to 30 stable stocks that are optionable,
2. Invest in four to six of the best value plays from this list,
3. Write short-term (up to 90 days) covered calls – the premium should be >5% at a minimum,
4. If the stock is called away, replace it with the best value play from the list in step 1. If the option expires worthless, rollover by writing another short-term covered call or if the value matrix has changed, close the position and write another covered call, and
5. Revisit and update the core list in step 1 once every twelve months.

The strategy should ensure >20% annual income but will have downside risk. To minimize the risk of significant capital losses in the face of a correction, selectively buy puts against some of the positions. Below is a core list of 25 stocks (see step 1 above) that we have come up with:

Related Posts:

• Cash holdings in an investment portfolio - strategies to squeeze income for value investors
• Kelly Criterion based Strategies for Value Investing
• Covered Call Strategy for Stable Income Portfolio
• Basics of Options and Futures for Value Investors
• Basic Options Strategies for Value Investors
• Basic Futures Strategies for Value Investors
• Short Selling Strategy for Value Investors

Last Updated: 04/2012.