by Mike Scanlin

Covered calls can be used in many ways. Today we interview a professional money manager who has 3 distinct ways to use them.

Barry Martin is the Portfolio Manager for the separate account program at Shelton Capital Management a private wealth management company based in San Francisco.

BTS (Born To Sell): Barry, tell us a bit about you and Shelton Capital Management.

BM (Barry Martin): Shelton Capital Management has approximately $950 million under management. This is comprised of assets in 13 open-end mutual funds and Separately Managed Accounts (SMAs). We have been managing assets for over 25 years and about 5 years ago introduced our covered call strategies for the SMAs. Today we have approximately $100 million under management in covered call strategies.

As for me, I started off as a trader and made the transition to Portfolio Manager many years ago. During this time I obtained my CFA designation. I've been trading covered calls for about 15 years.

BTS: What are the different ways that Shelton Capital uses covered calls?

BM: We have 3 covered call strategies:

1. an ETF model portfolio with option overlay
2. an income strategy that has BXM (the buy-write index) as our benchmark
3. a concentrated stock position strategy to generate cash flow

BTS: Ok. Let's start with the ETF portfolio. How does that work?

BM: We have about 10-13 ETFs at any given time, and write slightly out of the money covered calls with durations of about 30-60 days.

BTS: Which ETFs are in the portfolio?

BM: It varies but currently we own SPY, IWM, EEM, EFA, GLD, IYR, DBC, TLT, AGG, TIP and USO.

BTS: What kind of call premium do you generate by writing calls on those?

BM: In the case of the ETF strategy it is more about smoothing volatility and not so much an income oriented strategy. This strategy is diversified and conservative in nature (my mom's IRA is in this strategy). That being said, the premium generated is generally around 2% per year.

Our benchmark for comparing performance on this strategy is the Dow Jones Moderately Conservative portfolio. In 2012 the benchmark had about 8.2% return while we had about 11.7% return, and we had less volatility (lower standard deviation) than the benchmark.

BTS: Tell us about your covered call income strategy for your SMAs.

BM: Our income strategy is referred to as the Optima Equity Income Strategy. We maintain approximately 20-30 stocks in the strategy and use covered calls to generate income. We typically write options that are 60-120 days out. Our top holdings include such stocks as PM, MS, HES, C, WHR, CAM, R, T, and HD.

BTS: How has the strategy been working?

BM: Over the last 4 calendar years, we've generated cash flow in every 12-month time frame, typically 6% to 10%, and we've done so with less volatility than the market.

BTS: It's interesting that you write 60-120 day options; many option writers prefer the quick time decay of the 30-day options (or even weeklys).

BM: By writing 2-4 months out we're trying to avoid getting whipsawed. Many of these accounts are taxable so we generally want to keep the stock. We usually buy back the calls if they're going to expire in the money. In our experience, the 30-day options have a higher chance to whipsaw you before the stock has had a chance to revert to its mean.

BTS: Since this is an income strategy, do you focus on dividend paying stocks?

BM: Our average dividend yield is around 2% right now. We could buy higher dividend yielding stocks but they tend to have lower volatility, which is not so good for call writing. We've found the 2% dividend yield is typical for stocks that have just about the right amount of volatility to write calls. You need some volatility or you won't get anything for the calls.

BTS: How has your performance been?

BM: Our benchmark for this strategy is the BXM, which writes 1-month, at-the-money calls on the SPY. In 2012 the BXM return was about 5.2%. We did about 9.9% over the same time period.

BTS: Ever sell naked puts (cash secured puts)?

BM: Sometimes we'll sell cash secured puts as a way to enter positions at a price we like, but they are less than 10% of the account. Mathematically, a cash secured put is the same trade as a covered call (for the same strike and expiration date) but conceptually sometimes it's easier to think of entering new positions as buying below current market price.

BTS: Do you ever trade weeklys or use margin?

BM: Haven't used weeklys yet. It is not our practice to use margin; however, there may be a rare instance when it is necessary on a limited basis.

BTS: How concerned are you with short-term capital gain taxes?

BM: Because these are separately managed accounts, each client's tax situation is different. If we're managing a taxable account, we will look at the short-term gain near the end of the year and usually have a way to manage that gain down by selling off some losing positions.

BTS: Tell us about your concentrated position management?

BM: Sometimes we'll get a client who has a large amount of one particular stock. Maybe they were an executive at the company for many years. If they have $1M or more of stock at a very low cost basis then the main thing is we can't let that stock get called away because of the tax event it would create. But at the same time, the client wants to increase cash flow from the position. And, of course, they want all the upside, too!

So we offer them a menu of choices. For example, we explain that we can increase cash flow but at the cost of putting a cap on their upside. Then we let them choose: Would they like to have 6% income and cap their upside at 5% or, 2% cash flow and cap their upside at 20%?

In general, we shoot for 2% to 6% cash flow (depending on client preference for upside cap) and we may also use a strategy of laddering covered calls with different strikes and expiration dates to achieve that goal.

BTS: Any advice for covered call writers?

BM: I have two suggestions: (1) If you want to keep your stock then don't write calls that are short-term and at-the-money. Instead, write longer dated options that are out of the money. And (2) Don't chase volatility. The super high premiums are there for a reason. It's better to look for medium level volatility in good companies with solid balance sheets.

BTS: Excellent. Thanks for your time today, Barry.

For more information on their covered call strategies, please visit Shelton Capital Management or ask your advisor.

Disclosure: This is not an endorsement to buy or sell securities. Investing in securities carries with it very high risks. The information contained within this interview is for informational purposes only and is subject to change at any time. Do your own due diligence and consult with a licensed professional before making any investment. Born To Sell has no affiliation nor has received any compensation from anyone or any company mentioned in this interview.

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.