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Generating Higher IRA Returns In A Low-Risk Way

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Generating Higher IRA Returns In A Low-Risk Way

If you’re seeking an increase in the investment returns of the stock you hold in IRAs, writing covered calls over them may be worth considering. This process offers little risk and a potential increasing in your earnings.

What’s A Covered Call?

A covered call is essentially selling call options on a stock that you already own.

The buyer pays a premium for the call option.

The seller takes on an obligation to sell the stock to them at a “strike price,” a pre-agreed value.

The Research

This is an option for long haul investors, so it should be stressed that good market research is key.

Writing covered calls is a better idea under some circumstances than others.

It pays to understand your portfolio and have a good idea where the market is headed.

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What’s In It For The Seller?

A covered call is a good way of generating income on the stock which you’re planning to hold for the long term.

If your research causes you to believe the price isn’t going to rise much, or stay flat, selling call options (of blocks of 100 shares) can generate income on the stock which would otherwise be static.

What If The Stock Falls?

Even if the stock price falls slightly, then the premium paid by the buyer should cover the shortfall.

It’s a safer position, as one already owns the stock.

So if the buyer does call, it’s already there to give to them.

The call is “covered” by the stock ownership.

Hedging Your Bets

Another good reason for writing covered calls is that the premium can act as a hedge against volatile markets.

Sometimes the premium can help you buy a stock which would otherwise be out of range.

What’s In It For The Buyer?

The buyer retains the option to buy the stock at the strike price.

If they believe the price is going to rise, they may well make a decent profit.

For example, the buyer bought the call option at the strike price of $10 per share.

Current market value is $17.

He calls the option, buys the shares at $10 and sells on at $17.

It’s worth noting, though, that options are time-sensitive assets, typically with a shelf-life of 3-9 months.

So as the option nears its expiration date its “time value” will decrease.

Good Option For An IRA

Not only does writing covered calls offer the chance of a steady income, but by their very nature, they’re a protected position.

This makes them ideal for IRAs.

The tax consequences are less of a risk in IRAs.

Even if a capital gain is generated, then the investor can buy back stock at a price to negate this, while keeping the profit made.

Buy-write vs. Buy-hold

Studies have shown that covered call writing (a buy-write strategy), on average, carries less risk than simply holding on to the stock (Buy-hold).

There are fewer losses, and cash flow is steadier.

Advantages Of Writing Covered Calls

  • A low-risk option
  • Can generate income on underperforming stocks
  • Works well for tax-efficient savings plans
  • Already own the stock

Potential Losses

The risk with writing covered calls is not in what you could lose.

More the possibility of losing out on what you could have won.

If your research is incorrect, and stock prices rise sharply, then you’ve lost the option of selling at the higher price.

This is known as “opportunity risk.”

Have To Have Stock To Cover

As discussed, this call can only be written on a stock you already own.

You can’t sell uncovered calls within an IRA; the potential losses are unlimited.

It’s why it’s a safe position, but it also means this is an option only for those with stock at their disposal.

Do Your Research, Know Your Market

One drawback of writing covered calls is that typically it requires more work than a simple buy-write strategy.

You need to pay close attention on a week-week basis to stock prices, and the strategy needs to be regularly implemented to generate regular income.

A Complex Option

Writing covered calls is not an option for the casual investor.

Unless you’re well-versed in trading stocks and options, it may well be best undertaken by investment professionals.

This has the downside of incurring fees and royalties.

These costs need weighing against potential gains.

Potential Pitfalls

  • Best done by investment professionals
  • Must already own the stock
  • Giving up some potential profit
  • More work involved
  • Some professional costs may be incurred

 

Conclusion

While involving some careful work, selling covered calls can yield returns of one to two percent extra per year.  

It’s definitely an option for the longer-term investor; don’t look to make short-term gains from writing covered calls.

But if you’re holding onto a stock for the long-term, it can generate returns which would otherwise have been impossible on the stock.

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