Wall Street's record rise spurs growth of covered call strategies

By Laura Matthews

NEW YORK, Sept 10 (Reuters) - For investors with portfolios of individual company stocks, Wall Street's record-breaking rise is boosting the attractiveness of an options strategy that helps them hedge single stock risks while earning some income as they diversify their portfolios.

While the use of covered calls is not new, portfolio managers said they are finding growing adoption of the strategy among individual investors with large positions in big tech stocks, baby boomers and corporate executives with legacy holdings gained from being paid in company shares.

One way advisors and managers are approaching the growth of their clients' single stock exposure is by using customized covered calls that let investors slowly sell out of stocks and diversify their holdings, as well as manage taxes.

In the covered call trade, investors sell calls on the stocks they own to earn extra premium income.

A call option gives the buyer the right but not the obligation to buy the stock at a set price in the future. The premium earned can be used to buy a put option conferring the right to sell to protect against losses.

Some portfolio managers estimate that up to $15 trillion of concentrated stock positions are ripe for covered calls and similar strategies.

"The concentration in the market is so much greater than what we've seen in the past, so, there are more of these cases," said Jake Marriott, options portfolio manager at Aptus Capital Advisors.

"The growth of ETFs (exchange-traded funds) and the use of options-based products are opening people's eyes to the possibilities and the different things you can do with options," he said.

The S&P 500 .SPX has risen 30% since a shakeout in April and is up 10% for the year, driven in part by advancing artificial intelligence-related technology stocks and the standout performance from defense-focused software upstart, Palantir Technologies PLTR.O, leaving holders with decisions to make on how to manage the gains.

Aptus is structuring the trades with shorter duration for about 50 individual clients' separately managed accounts (SMA), helping them deal with the risk in dozens of individual stocks from Amazon AMZN.O and Nvidia NVDA.O to Lowe's LOW.N and Walmart WMT.N, as well as portfolios of stocks.

SMAs are investment portfolios of individual securities directly owned by an investor and managed by a professional manager. That market itself is expected to rise to $3.15 trillion in 2025, up from $2.75 trillion in 2024, according to data from research and consulting firm Cerulli Associates.

"Advisors are thrilled to have a solution now for these positions that previously they couldn't do anything for. These positions were held on the side," said Aptus' Marriott.

TAKING MONEY OFF THE TABLE

The amount of money you can make from selling options depends on how volatile the stock or market is — the more volatility, the higher the potential income.

Because active covered calls are often traded in client accounts with other assets and do not have to be publicly disclosed, data on their use is limited.

But in general, covered calls have become increasingly popular over the years, evidenced by the growth of assets invested in exchange-traded funds focused on derivative income strategies. That totaled $150 billion at the end of July, up from about $7 billion in January 2020, data from Morningstar Direct show.

The first seven months of this year saw those funds take in more than $40 billion, some $22 billion more than the corresponding period for 2024.

"If you've made a lot of money in a single name, you may want to take some or all of it off the table and get in a diversified portfolio," said Tom Lee, chief investment officer at Parametric Portfolio Associates. "So, (people are looking at) how do you do that without creating a material tax liability."

Reasons for seeking an exit strategy vary by individual.

An investor with retirement income needs might sell covered calls more conservatively, focusing on options that have a low probability of being exercised at expiration, which raises the chances of keeping the premium and retaining the shares.

"I think we are likely to see an increase in these tax-efficient strategies in the coming years as home offices add these to their platforms and advisors and clients begin to better understand them and their use cases," said Michael Manning, a research analyst in the Wealth Management practice at Cerulli.

For purposes of diversification, investors can sell covered calls closer to the money. If the stock price goes above the call strike, the options generate a loss which is used to offset the taxable gains from the sale of some of the underlying stocks.

"It forces you to be disciplined," said Chris Murphy, co-head of derivatives strategy at Susquehanna. "It lowers the volatility exposure of investors. They give up upside in extremely strong scenarios, but it lowers their volatility exposure in every scenario."

Firms like Gateway Investment Advisers are already expanding to meet the demand, acquiring Belmont Capital Group in July, a provider of customized, options-based strategies for SMAs.

That large asset managers are also growing and expanding into the space, "is also signaling this is early innings," said Eric Metz, chief investment officer at SpiderRock Advisors, a wholly owned subsidiary of BlackRock BLK.N.