Covered Call Investing Strategies: Asset Allocation

Here is the first installment in the Covered Calls Investing Strategies Series: Asset Allocation

Asset allocation is a topic that seems to be missing from both many investors portfolio’s as well as many of the covered call bloggers which I have been following in order to write these segments. The general lack of diversification both between stocks and bonds as well as different sectors within the stock market has been covered widely by the media since the recession began. Many retirees fell victim to the “target-date” retirement funds which supposedly offered diversification based on an estimated year of retirement. Unfortunately, many soon to be retirees found out that these funds which much riskier, and much more heavily invested in equities than they should have been. As such, I think it is very important that any investor, be it a covered call investor or otherwise make sure that they are diversified.

For the covered call investor, the premise of asset allocation and diversification poses an interesting question. Due to the income generating nature of covered calls, is it important to have bond-like instruments in your covered call portfolio? Only one of the covered call bloggers (https://coveredwriter.blogspot.com ) has a bond etf as part of his portfolio, though he is the only person to do so. Generally, a bond etf does not have very high premium options, if it has options at all. This presents a difficult situation because in many cases it is not even possible to establish a covered call position. As such, it is my opinion that you cannot effectively include a bond position in your covered call portfolio. However, it is also my belief that you should have some bond etfs as part of your total investment portfolio.

In terms of diversification within equities, there are a few different factors to consider. The first factor is global diversification. As the US is becoming an increasingly smaller portion of the world economy, it is not wise to not carry any international stocks in your covered call portfolio. Jeff Partlow, the covered calls advisor presents his view of this fact in the following post http://coveredcallsadvisor.blogspot.com/2007/12/international-investing.html. As Jeff also notes, you must also have sector diversification. His suggestion is to invest in at least five of the following six sectors: Consumer (Staples & Discretionary), Energy (includes Materials), Financial, Industrial (includes telecom and utilities), Health Care, and Information Technology. I would personally not place telecom and utilities in the industrials bucket, but it is often hard to find mutually exclusive sectors. Where Jeff and I do agree is that diversification does not necessarily mean that you spread your investments equally across all sectors. There is some level of investing insight you must use from your own knowledge and experience to determine when you should overweight or underweight yourself in a particular area. As an example, when commodity prices hit their bottom in Jan-Feb of this year, a good move would have been to overweight yourself in energy and materials stocks. However, you must also know when to get out of a sector that has exploded. In the summer of last year, when oil prices were marching towards $200, and commodities were making new records every day, a wise move would have been to reduce your holdings in energy and materials stocks.

It is obviously difficult to diversify well, especially in a covered call portfolio (due to the need to purchase at least 100 shares of each stock) when you do not have a large amount of funds. However, you can always complement your covered calls positions with non-covered call positions where you hold less shares. Additionally, you could use etf’s which track various market indices to give yourself broad diversification and also allow yourself to write covered calls. Such etf’s include FXI, which tracks the China market, EWZ which tracks brazil, SPY which tracks the S&P 500 and others.

I would lastly like to point out that in my view asset allocation for a covered calls investor should include a portion of the portfolio is not covered. My personal method for this is to hold a few index ETF’s so that I add another layer of uncapped diversification. Although covered call writing provides downside protection which an index etf will not, it also provides a cap to your upside. Allowing for non-covered call positions in your portfolio will allow you to capture additional gains that you may miss if your entire portfolio is covered.

I hope that this post has been useful, and please comment if you have any other topics within asset allocation you would like me to discuss. I would also encourage the other covered call bloggers to post with their own comments on what I have said. Look for the next post in the covered call investing strategies series sometime in the next couple weeks. The topic will be the covered call position selection strategy.