For withdrawal stage investors.

We talk a lot about covered call writing. A basic option strategy viewed from three perspectives: 1) the cash flow advantage from the premium received; 2) the downside protection afforded from the premium; and 3) the fact that we pre-set a target provide for the underlying security. In short, we typically look at the strategy on the basis of its investment merit.

But what about looking at the strategy as simply an income alternative. Particularly for investors at the withdrawal stage of their life cycle… not the accumulation stage.

It’s an important distinction. And given the demographics, clearly something that many investors are interested in. For that reason, I have attached an Excel spreadsheet which is a simple Covered Call Calculator for Income Investors.

When we look at covered calls as an income only model, we take away some of the metrics that support it as a basic option strategy. For example, some or all of the premium received will likely be taken as income by the investor. Therefore, it no longer affords the same downside protection.

You could make an argument about the tax benefits from the strategy. Premium income being taxed as a capital gain, and assuming the underlying security pays a dividend, the favorable treatment accorded that cash flow. But in reality, it comes down to risk and the income investor is seeking a quality alternative to traditional blue-chip investments like government bonds, GICs and preferred shares. But enough of the pre-amble.

Let’s look at an at-the-money example using Bank of Montreal (symbol BMO, recent price $61.25, dividend $2.78). There are four reasons why I decided to look at this stock; 1) in terms of the stock, I think most of the bad news is priced in, which suggests minimal downside risk, and 2) its not a bad GIC alternative. In other words, to buy a GIC from BMO, you have to be comfortable loaning BMO money. If you are comfortable with that, you should be comfortable owning the stock.

Number 3) I believe the dividend will continue to be paid at current rates, and perhaps even increase and; 4) I am utilizing an at-the-money long term covered call write example, because I assume an income investor is not looking for upside potential, but rather, is seeking a tax advantaged income stream that is better than what is available in the high quality alternatives. The latter point accepts that medium term fixed income portfolio yields approximately 5.2%, so a tax advantaged income stream of say, 7% per annum should be attractive.

Given those assumptions, we’ll buy 1,000 shares of BMO at $61.25 per share ($61,250 total cost), and write the long term BMO January 2009 62 call LEAPs at $5.15 per share (for disclosure purposes, I have executed this exact position in my managed Income portfolios).

Normally, when looking at a covered call write, we would examine the net out-of-pocket cost to implement the position, the return if exercised, and the return if unchanged. However, for an income investor we should be looking at the strategy from a cash flow and downside risk perspective.

In terms of the cash flow, we are assuming the investor will draw 7% per annum, which over the next 15 months equates to $4,287.50 (based on a net investment of $61,250 which equals 1,000 BMO shares at $61.25 per share).

Next we want to know how much excess cash is generated, so that we can define what, if any, downside protection is available after the initial withdrawal. In the BMO example there is excess cash flow, and if we run the metrics using the attached Calculator, the downside breakeven after all holding period withdrawals, is $56.91 per share.

Bottom line, which for income investors is well… the bottom line. What is my cash flow? Can I get a reasonable amount of downside protection after taking my income? And finally, am I comfortable holding the underlying security longer term?