Covered Calls for a Living? Selling a Dream
Updated on March 8th, 2023
Covered Calls as an Investment Strategy
There are a lot of gurus out there that tout various versions of covered call strategies for monthly income. Some even claim to live solely off selling covered calls for monthly income against stocks already in their portfolio. It’s a great sales pitch, but it rarely plays out as nicely as described.
Luckily the concept is not complicated, so I don’t have to spend too much time creating filler material with payout charts and other diagrams like most of the resources out there do. In a nutshell, a covered call, or buy-write strategy is to buy 100 shares of a stock and then sell a call option derivative against those shares. If the stock price is above the call option strike price at expiration, the shares will be called away.
A covered call means that the call option is covered by the stock so that once the stock crosses above the call option strike price, your position becomes flat and you will not make or lose money as the stock rises. This is in contrast to a naked short call option where you are on the hook for each incremental dollar that the underlying stock price rises.
You get to keep the option premium whether you are called out or not and that is the goal of the strategy: sell as much premium as you can, and hope to keep the stock.
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The investopedia page has a more in-depth description of the covered call trade if you need more detail.
What Is Your Stock Purchase For
First ask yourself why you own the stock. Are you hoping for capital appreciation or yield? Or are you just trying to find any stock where you can consistently sell covered calls on?
Some just want to collect the highest premiums. These are usually for biotech stocks that are going to jump 50% in either direction based on some FDA decision coming out soon. You are trading a few bucks in premium for partial upside, or massive downside. Not a great trade.
Others use a covered call writing strategy to “double the dividend” by selling covered calls on high yielding stocks like AT&T, for instance. Don’t just pick the highest yielding, do the research.
As of this writing, AT&T is trading at about $30.50. A one month (36 days till expiration as of today) call option at strike $32 is trading for $0.77, meaning the 1 month yield is 2.5%, or 25% annualized on just the premium alone. The implied volatility of this option is 36%. Naturally, as you go farther downrange, the premium increases but at a declining rate. The implied volatility of the Jan 2021 $32 call option is 29%, so the call is trading at $2.13. That has an implied yield of 7%, or 9% annualized. So do you go for the higher annualized yield or the longer option? This is a critical point for the return on the covered call strategy.
The option premium just described is a pretty high premium for a high-yielding stock like AT&T. In lower volatility times, you have to sell the option very close to the current trading price to make the trade even half worth it. But in April 2020, implied volatility is very high after the market dropped 35% and then shot up 20% from the bottom in a month. The VIX is pushing 40+. The expectation is that stocks are making big moves in either direction, and the implied volatility is reflected in that option price, therefore option premiums are unusually high.
A month ago AT&T was $38. If you like AT&T, do you bet on its recovery to gain 24%+ and collect a 7% dividend in the meantime over a long period, or do you aim to collect a small amount of premium?
(Side point: To get qualified dividends, which have the lower tax rate, you must hold the stock within a 60 day period.)
An Option Is a Mathematical Expectation Of Future Value
I hate to break the bad news, but it’s an illusion that you’ll get steady income from stocks you just hold just by writing covered calls. The value of an option is not just free money lying around waiting to be harvested. The mid-point premium (dead center in the bid-ask spread), is the mathematical expectation of how much that option is actually worth. Theoretically if you bought or sold options at the mid-point without commissions you would break even over time.
In its most basic form, option value is determined by the Black-Scholes equation. I worked on a Statistical Arbitrage desk at a large options market maker in Chicago many years ago and they had sophisticated models for theoretical value. Trust me when I say they want an accurate assessment of what the option is statistically worth and they aren’t going to sell it to you for something less than that.
But, alas, you can’t even get the mid-point price! You’ll pay at least $5 ($0.05×100) away from that midpoint to buy or sell, but that’s only if you have a great brokerage that routes your orders to exchanges. Most of the brokerages route your orders to market makers who specialize in retail order flow and won’t even execute your order unless they make a minimum amount of profit off you (yeah, that whole commission free trading isn’t really free).
This is one of many things that makes Robinhood a poor choice for a brokerage.
In my younger years when I didn’t know the difference between price and execution and chose brokerages based on how cheap they were, I’d be lucky to get 10-15 cents from the mid. After paying the spread your statistical profit expectation is now negative (Additionally, while brokerages recently removed ticket charges of $6-10 per trade back in October 2019, you still pay $0.65-0.75 per contract and exchange fees).
Most stock options are not as liquid as AT&T. The more illiquid the options are on a stock, the larger the spread and farther from the midpoint you’ll get.
The Wheel Covered Call Selling Strategy
Here’s the problem: stocks and indexes move around. Stocks and indexes are susceptible to corrections and news developments. When you sell a covered call, you retain all the downside risk and cap your upside return.
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Some have said that you should only sell covered calls during sideways markets; great let us all know when that is scheduled on the calendar. Or they say that you should only do it on stocks that move in a channel.
This channel idea is expressed with the “Wheel Selling Covered Call Strategy” where you start by selling a put at the lower range of the channel. If assigned, you turn around and sell a call at the top of the range, and then repeat. Around and around we go.
It sounds good, but how many channels have you seen where you can continually run this strategy over and over again?
Let’s play a game. Here we have my favorite example of Lockheed Martin (LMT) where it was going sideways for three years. Find the channel:
Would you have sold your initial put at $51 and your initial call at $58? What do you do when it rallies to $62 and you are called out? Do you sell a put back at $52 for a paltry premium or do you sell a put at the previous channel top assuming it has formed a new channel?
Let’s say you went for the old bottom to be conservative. You get assigned at $52 and start selling calls at $54, and you get a few months premium. This is easy money! You are called out again, so you start selling puts for pennies at $50 once again. You are never assigned and it goes back to $60. Your premium is back to pennies.
And then this happens right after getting called out of your position:
Congratulations you’ve just traded a few bucks of premium in exchange for missing out on $300 or 500% return!
Do you keep selling puts at higher and higher strikes hoping a new channel will form?
What if the stock then drops 20% under your put strike. Do you sell a call at your entrance price for pennies, or wait for it to climb back to the top of the channel to sell for a higher premium? Or do you sell close to the money calls as it continues to fall down to reap that higher premium, but lock in a loss if it turns higher? What would you have done after selling a put mid February and your stock dropped 50% in a week? Where do you sell your top side wheel call? The whole selling covered calls for income strategy starts to fall apart on a significant downside move.
Channels are pretty fleeting. You’ll probably get a few month’s call option premium out of it, but maybe you should have just owned the stock if you liked it instead of trying to squeeze more out of it and then missing out on additional upside.
(By the way, back then LMT was yielding over 5% with a P/E under 10, the call premium was pushing the yield to over 15% annualized)
Systematic Covered Call ETF
Let’s say you leave it to the professional money managers to do this in a systematic way. They spent millions of dollars researching the rules of the strategy and launching the funds. Certainly they put a lot of time and effort into coming up with something good right?
The buy-write covered call fund on the S&P500 with the oldest inception date is PBP (Dec 2007). How has it performed against the S&P 500 since inception? Massive underperformance:
Pick any time period and it will also show under-performance. There are several other funds that had launched a covered call strategy at one point but then closed within a couple of years due to under-performance.
Some people will focus on the reduced volatility of the strategy, thinking that therefore the risk-adjusted returns must be higher. But that is not correct. While PBP does have a lower beta, meaning it is less volatile than the S&P 500 trust, it also has negative Alpha. The Sharpe Ratio is half that of the SPY index fund’s, meaning the risk-adjusted return is half.
Compared to the S&P500 SPY trust:
No matter which time period you examine, it had lower risk-adjusted returns than just buying the S&P500 outright.
There are still a few other buy-write funds in existence that vary their strategy, but they all under-perform as well.
There is no magic here. Your upside is limited but your downside is not.
The Put-Write Strategy
If you are comfortable with selling covered calls, are you comfortable selling covered puts (cash secured puts)?
Mathematically the payout relationship of selling a covered call is the same as selling a cash-secured put. You only have to trade one item instead of two simultaneously. However, with volatility skew creating a smirk on the implied volatility surface where lower strikes have more implied volatility, you should theoretically get better performance for selling more vol.
Unfortunately theory and practice are often at odds and the Put-Write fund (PUTW) has under-performed as well:
It has even under-performed the PBP Buy-Write ETF. And since this fund hasn’t existed for more than 5 years, the Morningstar Sharpe Ratio only has the 3-year figure: Sharpe-Ratio of -0.4. That’s a negative.
Covered Call Tax Treatment
The covered call strategy is a tax monster. The key point for the taxation of covered calls is the short call option component of the trade. Short options are always taxed at short term capital gains rates regardless of the holding period. If your holding period for the underlying is also short term, when called out, any gains on that will also be taxed as a short term gain.
Taxes aren’t necessarily bad because it means you are making profits, but your return has to increase by your marginal tax rate just to get you above what buying and holding long term would have been.
For instance, if the S&P 500 is expected to earn 8% annually with all taxes deferred for decades until retirement, and your marginal tax rate is 22% + 5% state tax, you will need to earn nearly 11% a year from the covered call strategy just to “break even” after employing the effort and paying taxes.
You of course can remove the tax drag by using an IRA account.
At the beginning of April 2020 with the market depressed and expected to recover after the COVID crisis is a distant memory, history suggests forward returns will be larger than the historical average. After 2009 until the beginning of the latest crisis, the market had returned 17.8% annualized. Is now the time to be capping your upside?
And if professional covered call funds can’t outperform, why do you think you have an edge?
Covered Call Writing Summary
I’m not saying it’s impossible to have a covered call strategy that performs better than these funds, just the same as I’m not saying that you can’t pick individual stocks that beat the market. You can. But if you think there is some blind mechanical strategy out there that is just going to mint money by buying low and selling high, you will learn the hard way soon enough.
And don’t get me wrong, I’m not against options. I use them all the time, but for different reasons. I just don’t use them for covered calls unless I am trying to sell out of a position purposefully. Or if there is a stock I am interested in buying at a lower price, I will occasionally sell a put if I think it might go lower. I’m also a big fan of vertical spreads for speculation.
If used properly they can be powerful tools. I just don’t think covered calls is one of them.
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