Federal finance Minister Jim Flaherty dropped a taxation bombshell after the close of trading on Oct. 31. Although changing the way income trusts will be taxed had no real impact on the after-tax cash flow of taxable investors who hold income trusts in non-registered accounts, it did have a major impact on their net worth.

The government’s surprise announcement highlights the importance of trying to reduce risk through diversification. Obviously, this is not a new concept for inves-tors in the accumulation phase of their life cycle. However, it is less common for investors who are in the withdrawal phase of their life cycle.

Income-seeking investors tend to look at investments that are tied to interest rates. Bonds, preferred shares and, of course, income trusts fit that criterion. The problem is that investors holding these three security classes think they are diversified; but, on a macro basis, they are not diversified.

From a macro perspective, these three securities trade on the basis of their yield and, as such, are all subject to revaluation given a change in interest rates.

The unique tax structure associated with income trusts was different from bonds and preferred shares, which means, from a diversification perspective, that income trusts did bring something to the table. But in doing so, they opened the door to a risk that most clients had not anticipated.

The bottom line is that investors seeking yield should build diversified income portfolios. To do that, investors need to adopt some strategies in which interest rates are not the only determining factor.

And, because covered call writing is an equity strategy that produces premium income, it is a good choice for investors seeking income. The income from the option premium is taxed as a capital gain, which diversifies the taxable cash flow from interest income (bonds) and dividend income (preferred shares and income trusts).

Moreover, the major factor impacting covered call writing is volatility. The higher the volatility, the more premium that is available for the covered writer.

But, unlike the other assets, changes in interest rates have only a minor impact on the covered call writing strategy.

Yet, for investors who are not at the withdrawal stage of their life cycle, covered call writing is not particularly attractive in a low-volatility environment. For this class of investors, covered call writing does not provide enough downside protection to justify limiting upside potential.

But for income investors who have a diversified income portfolio, upside potential is not the issue. Rather, it is about using covered call writing as a portfolio diversifier and income generator.

Because the metrics for covered call writing are different, the strategy can make sense for income investors — even in a low-volatility environment.

During periods of low volatility, some covered call writers are tempted to write (deeper) out-of-the-money options, hoping for a stock price rise to produce superior returns, thereby relying less on the option premium itself to produce those returns.

This results in a more bullish slant to the strategy, which might be appropriate for someone in the accumulation phase. But it is probably not appropriate for the income investor.

Further, according to Lawrence McMillan, president of Morristown, N.J.-based McMillan Analysis Corp. (www.optionstrategist.com), when you look at the bottom line: “Writing out-of-the-money calls does not generally increase the expected return at all.

“All it does is increase the maximum return. But the downside exposure created by writing an out-of-the-money call just about exactly offsets the extra potential from the increased maximum return.”

For income investors, the better approach would be to make a decision about a specific covered call write by looking at the statistical volatility of the stock rather than the anticipated stock price direction.

In other words: “If a stock that is expected to remain stable or fall slowly produces a superior expected return, that stock will be chosen over a bullish stock with average or negative expected returns,” according to McMillan.

“The expected return calculation will determine what strike returns the right amount of return, which is at least 12% [annualized] on cash accounts and 20% [annualized] on margin accounts,” he adds.

Typically, the covered write that meets the minimum expected return criterion is one in which the written option is slightly in-the-money — all the while keeping in mind that there is no black box that will tell you the correct covered write.

@page_break@For investors who would like to learn more about expected return, McMillan offers an expected return calculator that I believe is invaluable for serious traders.

The information on the calculator can be found at www.optionstrategist.com/products/analysis/software/index.html. IE