Equity markets are volatile to varying degrees over time and, as a result, expose investors to significant downside risk. Selling call options on stocks held in a portfolio is a way to generate income, reduce downside risk and benefit from that volatility.
Forgo some upside in exchange for income and downside cushion
Covered call overwriting strategies systematically sell short-dated call options on portfolio holdings. The seller of a call option earns the option premium which can add an income stream to their portfolio. Furthermore, selling call options on held stocks tends to reduce the portfolio's overall sensitivity to the market, thereby reducing downside risk somewhat. In exchange for the additional income and the downside cushion, the call overlay will limit the upside participation of the portfolio.
For our Equity Income strategies, we sell call options on single stocks held in the respective portfolios. Selling stock options instead of index options helps minimize basis risk and the risk of being net short any of the stock-plus-short-call combinations. Those call options usually have a tenure of one month and are rolled on expiry. Typically, options are held until expiry and replaced by selling new call options. The strike price is normally set at a minimum of 105%, so that each holding should have an upside participation of at least 5% during the life of the respective option.