If you’re looking at client investment portfolios and they are red from the beating they took last year, you’re not alone. There were few places for anyone to hide in 2022. Stocks, after spending most of the year in a bear market, suffered their worst 12 months since 2008. On the fixed income side, many parts of the bond market posted their biggest losses in history, with the effective federal-funds rate ending the year at 4.25%-4.50%, up from zero. Volatility was relentless from bell to bell.

While 2022 was a painful year, there was the occasional bright spot. Truly defensive companies, like stable, high-dividend payers performed relatively well. So, too, did covered call funds, and for a similar reason—strong dividend yields and some downside protection. Perhaps there’s something to learn?

For advisors, one lesson learned from last year’s bloodbath is that if used correctly, options can be more than just a tool for managing volatility; they may offer a way to capitalize on it. As market volatility picks up in frequency and intensity, premiums received from selling options tend to move higher, thereby offsetting some of the damage from falling stock prices.

Given current market conditions, owning high-quality names while selling covered calls to dampen volatility and generate cash flow might be one of the more attractive approaches to today’s market.

Covered Calls In Action
Covered call writing is an investment strategy that combines owning stock with selling listed call options on the stock, also known as writing. With the trade, the call option seller (or call writer) receives a premium from the call option in return for an obligation to sell the stock at the exercise strike price.

Importantly, the strategy generates cash flow in the form of the options premium and does so without exposing the portfolio to additional risk beyond "opportunity risk.” Should the stock price fall, however, the transaction produces a fixed return for the call writer. It’s no surprise retirement plans and endowments have been using call-writing strategies for decades. Of course, there is the fundamental risk as well that in some circumstances the call option seller (or call writer) could be obligated to sell the stock when it otherwise would not, whether due to adverse tax reasons or otherwise.

Put in practice, an option overlay strategy that succeeds in reducing the portfolio’s directional exposure reduces portfolio volatility. Take, for example, an advisor who writes a covered call on long stock positions. Say the stock is trading at $100, and the advisor writes calls with a strike of $110 that expires in two months and in exchange receives $1.50 premium. Clients still have $10 of upside potential during those two months, the difference between the stock price of $100 and the strike price of $110.

If the stock goes up beyond $110 clients would miss out on additional upside. However, if the stock stays below $110 through the call’s expiration they keep the premium and find themselves ahead by 1.5% (the premium received relative to the stock’s value when it was written) in just two months. Whether the stock has gone down, traded sideways, or gone up to $105 clients are better off for having written the call. Once expired, the call can be written again with a new strike price and expiration.

When volatility is elevated, so are call premiums. This means that clients can receive more money for selling a call, or they can write calls that are farther out of the money and thus retain more upside potential in the stock. While there is a chance of missing out on some upside when writing calls (i.e., having to sell the stock if the option is exercised), the premium received can buffer downside in a falling market or add yield in one moving sideways.

Ultimately, writing calls reduces the overall volatility of an equity portfolio, and in markets as volatile as those we have experienced recently that can be a big advantage in its own right.

A Risk Management Option For The Storm Ahead 
Without attempting to predict the stock market, it’s reasonable to expect more volatility, slowing growth, and rate increases both domestically and abroad. Most observers think the Fed will continue hiking rates, albeit at a slower pace than it did in 2022, in an effort to curb inflation. Against these expectations, we believe a covered call strategy is a good place to hedge one’s equity exposure.

There are a variety of ways an advisor can seek to limit volatility in his or her clients' portfolios. A well-managed option strategy should one of them.

Nick Griebenow, CFA, is a portfolio manager at Shelton Capital Management and the Shelton Equity Income Fund.