High income professionals often find themselves in a tricky situation: they hold a concentrated stock position, often with significant unrealized gains, and want to diversify without triggering a major tax bill or entering a long lock-up agreement. Two common strategies to address this are Exchange Funds and Covered Call writing. While both can be useful, covered calls offer a more flexible, income-generating, and liquid alternative, particularly for investors who want to retain control over their shares.
What Are Covered Calls?
A covered call is an options strategy where you:
- Own shares of a stock (e.g., Apple, Tesla, etc.), and
- Sell a call option on that same stock.
The call option gives the buyer the right, but not the obligation to buy the stock at a predetermined strike price within a specific expiration period. In return, you receive a premium, which is yours to keep regardless of what the stock does.
Example:
You own 10,000 shares of ABC Corp at $100. You sell 100 call options (each covers 100 shares) with a strike price of $110 expiring in one month. You collect $2 per share ($20,000 total) in premiums.
- If ABC stays below $110, you keep the shares and the premium.
- If ABC rises above $110, the shares may be "called away" at $110, but you still keep the $20,000 premium.
Why Investors Use Covered Calls for Concentrated Stock Positions
1. Generate Income Without Selling
Holding a large position in one stock can be risky, especially if the stock doesn't pay dividends. Covered calls allow you to earn monthly or quarterly income via premiums, without selling the underlying shares.
This income can be reinvested into diversified assets (like ETFs or bonds), effectively reducing your portfolio's concentration without selling the original stock outright.
2. Gradual Diversification
Instead of making a one-time sale that may trigger large capital gains, covered calls allow for incremental liquidation, only if the stock rises above the strike price and the shares are called away.
This gives you time to:
- Control the pace of diversification
- Use premium income to build a more balanced portfolio
- Strategically plan tax-efficient sales
3. Lower Volatility and Downside Buffer
The premium you receive acts as a downside cushion. While it doesn't eliminate risk, it does reduce your breakeven point and portfolio volatility, which is important when your net worth is tied up in one stock.
4. Maintain ownership
You continue to own your shares and receive dividends (unless the option is exercised)
Why Covered Calls May Be Better Than Exchange Funds
Exchange Funds allow you to contribute your concentrated stock into a diversified pool of other stocks without immediate taxes. In theory a great idea, but they come with major drawbacks:
❌ 1. 7-Year Lock-Up Period: Once you contribute to an exchange fund, your shares are locked for several years.
Covered Calls: No lock-up. You can unwind or adjust at any time.
❌ 2. Lack of Transparency and Control: In exchange funds, you don't control the other stocks in the fund, nor the investment decisions being made.
Covered Calls: You stay in control of your shares and strategy.
❌ 3. Limited Liquidity: You cannot exit early from an exchange fund without penalties or adverse tax consequences.
Covered Calls: Fully liquid and adaptable. You can buy back a call option, Roll or stop the strategy at any time.
❌ 4. High Minimums and Complexity: Exchange funds often require $500k-$1 million minimums and accredited investor status.
Covered Calls: Available to any investor who holds 100 shares or more of a stock.
Considerations and Risks
While covered calls can be an effective strategy, it's important to understand the limitations:
- Timing risk: You need to actively manage the strategy, deciding when to roll options or let them expire.
- Tax implications: Premiums are typically taxed as short-term capital gains
Is This Strategy Right for You?
Covered calls work best for investors who:
- Have concentrated positions in relatively stable stocks
- Are comfortable with potentially selling their shares at the strike price
- Want to generate additional income from their holdings
- Prefer flexibility over the long-term commitments required by exchange funds
- Have the time and knowledge to actively manage the strategy or allow someone else to manage it for you
As with any investment strategy, it's crucial to consult us or other fidiciury advisors and assess your specific situation to help determine if covered calls align with your overall financial goals and risk tolerance.