Covered Calls: The Best Method for Financial Independence
You need a lot less than you think to make a living income selling covered calls
Financial independence is a huge topic on finance Twitter. Last week, I asked this question:
I got some pretty interesting answers. Most people said something between $5 million and $10 million, which I think is very high for the average person with a normal lifestyle.
Assume you can yield 3% on your $5 million portfolio, a pretty low dividend yield historically. That’s $150,000 annually, not counting any capital appreciation you might experience. And 3% is definitely on the low side; someone with a bit of experience could easily yield closer to 5%.
So how much do you really need?
To live a normal existence off of dividends alone, I think $3 million or so is a good target. You’d be yielding about $100k initially (assuming your portfolio mirrors the yield of the Vanguard High Yield ETF, VYM) and your dividends and capital would grow each year.
But there’s a strategy that could make you financially independent with less money: Writing Covered Calls.
Say you own 100 shares of Square (SQ). In my opinion, it would be a great long-term hold considering the growth of online payment processing.
Your 100 shares would be worth about $23,360 as of today at $233.60 per share.
You could sell the July 16th, 2021 $260 calls for $2.10 per share right now, or $210 per contract (one contract represents 100 shares).
The calls are about 11.3% out of the money and have 24 days until expiration.
Now let’s say you have $1 million in your portfolio and repeat this process with your available capital. Of course you wouldn’t only do this with one stock, but let’s you pick 10 stocks that average out to the same situation as Square just for simplicity.
You’d be able to purchase 42 lots of 100 shares (4,200 shares) and still have about $19,000 left over.
Let’s say you sell those covered calls on all your shares: $210 x 42 contracts = $8,820.
That’s $8,820 in cash you receive right away. You could either pocket that amount and use it for your living expenses, reinvest it in your portfolio, or a combination of both.
This return implies $134,137 over a year, or a 13.41% return on your capital. Of course, you’re limiting your capital appreciation with this strategy. Ideally your $1 million has appreciated by 5 to 10%, but it will be hard for it to have appreciated massively after selling covered calls.
You’ll have to pay ordinary income taxes on that amount, just like any other work you would do to make $8,820.
The downside: The biggest downside of the covered call strategy is that your stocks may spike and you’ll actually make less money than you would have if you simply held the stock.
For example, let’s say Square has a great month and goes up 20% to $280.32. You still keep that $8,820, but you are forced to sell your shares at $260 at expiration. That means you left $20.32 in upside per share on the table, or $85,344 across your whole portfolio. If you consistently make this mistake with your covered call portfolio, you’ll make good cash flow, but you’ll miss out on a fortune of capital appreciation.
So the biggest key for a covered call portfolio manager is selecting calls that are close enough to the money to create a strong yield, but far enough out that they won’t expire in the money. Important note: with this strategy, my trade is a net positive if Square closes anywhere below $262.10 at expiration ($260 + the $2.10 I received for the call).
Another risk to know about this strategy is that implied volatility of options is near all-time highs right now, so the opportunity for lucrative cash yield in the covered call space won’t always be this juicy.
You’ll also end up spending much more time analyzing companies than you would parking money in high yield ETFs, since you’ll need to have an understanding of the option market for each portfolio company.
One other wrinkle I will add: If you don’t want to always have covered calls on your books that could limit upside of your portfolio, you could only sell covered calls when the stock and IV spike, then buy back the calls a day or two later after you’ve made a 25% to 50% gain on the calls.
Very nice Start of write up about Covered calls. Thanks. -Raj.