Many investors end up with concentrated equity positions over the course of their investing tenure. Some may receive equities from an employer as part of their compensation or retirement package; others inherit concentrated equity positions, while some investors may just really love a stock and amass their own concentrated positions.

While the traditional wisdom is to diversify, some investors may be unwilling to act. Concentrated positions may have large unrealized gains that would trigger unwelcome tax payments, or there may be a sentimental attachment for not selling (especially if inherited from a beloved family member).

Regardless of the reason to not diversity away from a concentrated equity position, there may be unmet investment needs  innovativeportfolios demo url   that could be solved by incorporating equity  options in the portfolio.

With the need for consistency of income and for tax efficiency, a number of strategies can be employed by using equity options alongside equity positions, each with unique benefits and risks. This article by James “Louie” Humphries, derivatives portfolio manager at Innovative Portfolios, explains covered calls. It represents the first post in our series on the different ways in which equity options can be used as an investment strategy for concentrated equity positions.

Covered Calls

A covered call is an options trading strategy in which the trader sells a call option while owning an equivalent amount of the underlying security. It is generally “written” (sold) at a strike price above the current price of the underlying equity (a portion of the concentrated equity position). See a visual representation below, in which point A is the strike price of the call option written, and in which the blue line represents the maximum potential gain or loss. The seller is obligated to sell the stock at the strike price.  (Source: optionsplaybook.com)

Possible outcomes of a covered call transaction:

• Selling a covered call on a concentrated equity position can produce income in the form of premium that is collected when the option is sold—and all with a goal of the option expiring worthless. (You want the price of the underlying equity to be at or below the strike price at expiration. If it is above the strike price at expiration, the option will be assigned and the stock “called away,” thus creating a potential tax liability.)
• Maximum profit is limited to the premium collected when the call option is sold. Potential loss is mostly embedded in the underlying stock, in that this option provides no protection to a downward move in the stock price. Opportunity cost may also be a concern. The stock price could appreciate quickly to the upside and those gains missed if the option is assigned.

A covered call does have some inherent risk and can cause a portion or all your stock to be called away through assignment. For those reasons, there are several considerations when using this strategy for income generation.

Best practices to consider:

• Not setting the strike price too low because, while that increases the premium collected, it also increases the likelihood that the stock will be called away through assignment. Instead, sell the call with a strike price you would be happy to receive if you were to sell the stock.
• Using only a portion of your underlying position, which limits the likelihood of the position being called away or of missing a large upside.
• Laddering the calls to allow writing over a series of strike prices and/or expiration dates.
• Not “chasing” call options, but being willing to let the stock be called through assignment.

Option overlay strategy for concentrated equity positions

There’s nothing new about option overlays. In fact, the majority of U.S. pension plans have adopted overlay techniques as part of their investment tactics, using derivative investments with an underlying securities portfolio serving as collateral. In this period of higher market volatility, it may be timely to incorporate protective portfolio tactics such as covered call overlays on concentrated investment positions.

Finding investment solutions for clients with large portfolios of low-basis, single-stock positions can be the impetus for advisors to outsource derivatives investing to Innovative Portfolios.