Couldn't an ERE'er just live off monthly covered call premiums?

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Lemur
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Couldn't an ERE'er just live off monthly covered call premiums?

Post by Lemur »

And what would be the pro/con of this strategy versus the most well known strategy of just living off a 3-4% withdrawal rate? Here is some napkin math I did today:

Suppose you own 1,000 shares of Microsoft (MSFT) that is currently trading at $162.11 a share. The cost basis here is $162,110. Using real-life numbers on the option chain (not a number I just made up), you could sell 10 covered call contracts at the current mid point price ($2.15 a contract) for the $180.00 strike price expiring March 27 (one month out). In this strategy you would aim to pick a strike price that is roughly 10% above the current stock price. Your total premium here is $2,150.00. This is a 1.33% return for the month (premium / cost basis). Annualized (if repeated every month) is 15.92%....counting annual dividends (1.295%), this is 17.21%.

[*] A 3% withdrawal rate on this asset is $4,863.3 for annual or $405.28 a month. Not even 1 JFI.
[*] A 4% withdrawal rate on this asset is $6,484.4 for annual or $540.36 a month. Not even 1 JFI.
[*] Collecting 12 premiums over the course of the year, assuming each one will be for $2,150, totals $25,800 a year which is enough for most ERE'ers (~ 3 JFI worth).

So what is the catch or important considerations that I am missing?

If the stock goes down, that is okay anyhow since in reality I would assume you're not going to be putting your entire net-worth into one stock like MSFT. Perhaps you would spread this out over 8-12 stocks to diversify risk and sell covered call premiums on each stock. I would prioritize blue-chip stocks that are not going anywhere for a long time + a bonus if it has a good dividend as well. One may even prioritize a stock that has a good dividend and trades relatively flat. Something like AT&T that you could combine its 5% dividend yield with selling covered calls.

An ERE'er that makes the median income of $55,000 a year and saves 70% ($38,500) could accumulate $192,500 without even investing in just 5 years. That would even be more then enough money to execute the above strategy.

And if the stock goes up and passes the strike price and you miss some upside? No big deal...you're retired anyway and just doing this for the income. You get your money back (and at a 10% gain at that since you chose a strike price 10% above the current stock price) and you could likely buy back 100 shares of the stock or buy more shares into the other stocks you own that have been discounted lately. Alternatively, picking a strike price just 5% above the current stock price when you sell your covered call for the month would net you an even higher premium.
Last edited by Lemur on Sat Feb 29, 2020 7:07 pm, edited 1 time in total.

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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by jacob »

Suppose the stock goes down from 100 to 70 and your 110 call expires OTM. So far so good. But which strike will you write the next call at? 80? Suppose you write it at 80 and the stock recovers and goes up to 90. You got the option money but if you want to repurchase the stock, you need 90, but you only have 80.

FWIW, there are at least some funds that do this automatically writing calls just OTM generating lots of income (about 7-10%). However, their actual value tends to decline when the stock market is increasing or decreasing. As this happens, the yield stays the same but obviously you're getting less $$$.

In summary, this only works if you have some alpha to contribute in terms of when and where to write the calls. Otherwise you're just making a synthetic product that converts beta into income. And for that you might as well hold a bond.

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Lemur
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by Lemur »

@Jacob

I like that link - didn't know that something like this existed. And here i am thinking I might have had an original thought ...I knew this was too easy and there had to be a catch though.

When I initially thought of this strategy, I tried combing the covered call with a put but often found that the insurance against the downside was too expensive. So that couldn't work. Trading upside for less risk and income is the goal.

So as far as the strategy I had outlined, if the stock goes down from $100 to $70 you would write the next call at $77 (10% above) or something close to that depending on how the option chain is split up. I do believe in this case your premium would decrease as well since the underlying decreased. That would be a con...and as your example shows; this is true - if you missed the upside up to $90.00 you could not repurchase the shares. Another con. However, you could also take your money elsewhere since the stock also just had a large upswing that isn't likely to happen again. Perhaps find another blue-chip that is closer to its 52-week low but isn't a falling knife due to its own fault. Con here is too much speculating though.

So what to do in this case....

A quick thought...you need 100 shares regardless for a contract. So to enhance this strategy...each of your stocks would need a buffer of 100 shares (more money). So, in reality, you would want to own 1100 shares of MSFT and still sell 10 contracts leaving 100 shares on hand.

Thinking - How could this strategy be enhanced with another type of buffer....

In any case, I'm failing to see why this wouldn't be a viable alternative. Another thought - the $25,800 income above would require $645,000 in assets at a 4% withdrawal rate whereas this covered call income generating method can be done with $162,110 (okay assuming that everything goes well 12 months in a row that is a breakdown).

Picking a networth somewhere in the middle ($403,555) and executing the above with $200k or so on stocks and $200k or so in bonds/cash (maybe this is your buffer if you need to buy back stock when it had its large upswing?) could be a great alternative and would save someone years of saving. However, I think this is spinning the wheel and is the ultimate con...in theory this buffer would run out eventually wouldn't it? ....

Laura Ingalls
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by Laura Ingalls »

Certain types of markets work great for covered calls. Others don’t.

DH writes covered call’s from time to time. Usually on stocks he likes but thinks have run up too far too fast. Sometimes as a way to force himself into selling something that’s success is jacking with our desired asset allocation.

At times it has been a nice little income stream. It’s never been the biggest in our post FI/semi retired life.

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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by bigato »

Actually I know a early retired guy who has been doing exactly that for over 15 years!

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Lemur
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by Lemur »

@bigato

Very cool! May work on collecting data and running simulations. With and without buffers mentioned in my second post. This could be very fun project.

At the end of the day though, could this strategy be more effective and worthwhile then simply saving the assets for 3 or 4% withdrawal rate? It is not nearly as robust though given some extra thought.

Because @Laura Ingalls brings up a very important point. "Certain types of markets work great for covered calls." We have to find a way to adjust given the market. If the market is falling - this strategy fails. The premiums would go down...your underlying assets go down....this is where your buffer could come into play to pick up the stocks on the cheap but you would be engaging in timing. If the market is rallying too fast - as @jacob mentioned; this could also be a con. You miss too much upside, cannot buy back shares, and then when the market corrects you're in a further bind.

This strategy works well in a neutral market....where stocks are increasing slowly but not forcing you to exercise and not decreasing so much that your premiums are taking a hit.

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Dream of Freedom
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by Dream of Freedom »

The impression of what you can make doing this is likely exaggerated. You ran your numbers right after a huge upswing in volatility. So the premium represents more potential movement than normal.

Another issue with covered calls is asymmetric risk. If the stock goes down you can lose far more than you can make.

You really should consider in the money calls instead. The extra premium that comes with the intrinsic value gives you more of a buffer if the stock goes down. Also because of skew, lower strike prices tend to pay more even after you consider the intrinsic value of the option. Shorter time frames of weekly options are your friend in this instance because you want to maximize theta. The theta decay increases exponentially near the expiration date.

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Lemur
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by Lemur »

@Dream of Freedom

Ah. That is a good point. The volatility in the market created more extrinsic value so when I was looking at MSFT option prices, I was not looking at normal pricing conditions. Asymmetric risk is there as well but I don't think is a huge factor if one is spread over 8-12 stocks. Perhaps one of the buffers for this plan would be to have an extra premium be used to buy one of the stocks that took a dip.

Interesting point on buying ITM call options....the cons I see with this I see is that if one is doing this on a monthly basis there is a good chance at least half of the stocks would end up being exercised by end of month. There would be transactional cost increases as well as having to be in a waiting period due to wash sale rules...perhaps that wouldn't be so bad though? If one writes an ITM call options the premium would be so much more higher due to the inherent intrinsic value priced in the option. I took a look at some P/L graphs and I did indeed so much more downside protection but I was surprised that not as much upside was traded away due to the much higher premium.

ToFI
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by ToFI »

It works sometimes but doesn't work in the long term because of two extremes: Stock rises/drops rapidly from strike price in either direction. When the stock rises too much and gets called away, you have to buy it back at a higher cost which the premium may not be enough to offset the higher price. When it drops too much, your new strike price is below your cost base and if it reaches strike price, you are selling below your cost base. Basically, it can mess up the average cost making it a losing position in the long term. It's the risk of selling stock low and buying stock back high. It's just not a sure thing. It only works if stock goes up smoothly and not above your strike price. You should not write covered call in bear market.

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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by bigato »

The guy I mentioned uses both covered calls and covered puts. The calls will pay him the premiums and if the stocks go too high, be sold at a profit. The puts will pay him the premiums and if the stocks drop too low, he will buy them. So depending on whether he needs to buy or to sell, he will use one of these. His goal is to get the premiums only, but it’s dimensioned such that the strike is reached, it’s also a win.
He uses a variant of the black-scholes of his own to estimate the chances of hitting the strike and adjusts the probability accordingly, depending on whether he wants to buy, sell, or just keep the premiums. He says this strategy works better when the market is going sideways. He has been averaging around 20% over inflation per year since he started around 15 years ago.

I did it for a while, but I didn’t think it was worth the trouble (for me). Because to make a difference, I’d have to move a bigger portion of my portfolio into it, and at the moment I prefer more passive strategies for the bulk of my investments. It’s one possible way to invest though, it’s a tool you can have in your toolbox.

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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by JCD »

When I initially thought of this strategy, I tried combing the covered call with a put but often found that the insurance against the downside was too expensive. So that couldn't work. Trading upside for less risk and income is the goal.
Keep in mind, you can play the put version of the same game too, if you are willing to play it on the other side.  Instead of holding 1000 MSFT, what if you hold 0 MSFT and simply sell 10 puts.  Assuming you have some sense of a fair price(*) for MSFT at the expiration of the option and put in say a 10% buffer, you might be willing to sell insurance to others and cheerfully accept MSFT if Mr. Market undervalues MSFT temporarily.  If material conditions have changed in a way you didn't predict (e.g. A certain virus shows up), you are at least 10% less worse off than if you held the stock.  Assuming a roughly equal premium in selling the insurance as in selling the call, you might make 15% a year.  The down side to this approach is you don't get the dividend, but you do get paid pretty well otherwise.  If you keep your cash in treasuries, you get that premium too.  If MSFT is put upon you, then you can sell call options above your purchase price or perform your own stop loss if the price goes too low for you.

(*) Using "experts", using models like DCF (Discount Cash Flow) or DDM (Dividend Discount Model) or using your own metrics.  Alternatively, trying to predict the market using technical analysis and timing your options to achieve the optimal result.

So in the example given, if you took a 10% discount of MSFT today (we are assuming today's price is fair value), and sold a put option at $145 for 4/3 expiration date, you could make ~$4.3x10x100 or about $4300 for a total of $140,000 at risk.  Assuming it expires worthless every time and you sell one a month for the next year, it would be worth $51.6k or 35% gain.  Of course due to panic, prices are inflated, but that capture the idea. If you sold a LEAP out to March of next year, it would give you a ~24% premium, which sounds closer to normal.  If MSFT got put on you, you simply get a 10+Premium% discount compared to the guy who bought the insurance from you. In that case with a LEAP, that is a near 35% discount for doing nothing but taking a insurance risk. Even if it is put on you, you probably get a sweet dividend that covers your 'base costs' and can sell covered calls, just like you suggested, if it just barely got put on you (say it dropped 15%). If it nose dived for good reasons, then hopefully you diversified. If the market all fell apart, that is the same sort of sequence of returns risk all retirees face, but at least you got your stock cheaper than straight out buying it.

If you think the market is way over priced and that a 50+% correction is due, you won't be able to sell insurance that low. If you don't have any idea what the value of the stock is, then you might end up buying high (e.g. 10% off a stock only worth 50% of its value), but that is a risk in buying a stock in any set of circumstances. There are other tools to solve these sorts of problems, but that captures the limits of the idea of selling insurance.

ertyu
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by ertyu »

Also, let's assume you keep your money in treasuries. Also assume you are assigned, and at the same time, treasuries experience an unfavorable price move. You must sell the treasuries to buy the stock you've been assigned, even if you don't like the price or if you'd rather not be selling.

So, you sold a put and got assigned, and now you must buy the stock too high compared to current mkt price + must terminate other investments unfavorably.

I'm told this is why I got screwed over with GDX this week - shouldn't have fallen in and of itself, but people needed to cover other positions to they sold out of their gold, which was the one thing falling less than the rest of the market - thus making it fall more.

JCD
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by JCD »

Also, let's assume you keep your money in treasuries. Also assume you are assigned, and at the same time, treasuries experience an unfavorable price move. You must sell the treasuries to buy the stock you've been assigned, even if you don't like the price or if you'd rather not be selling.
This assumes you bought long term treasuries, where you can lose money. Sure you can choose to risk up like that, but that is an intentional choice. I didn't get into this aspect as my post was already getting kinda long and this is a detail that can easily be handled. You might buy a treasury expiring in 11 months and sell a 1 year LEAP. That way the risk of resell at loss is near 0. You might want to be in a margin account purely for technical and timing reasons (e.g. put upon on month 10, as unlikely as that is), but it is easy to get around this down treasury issue with LEAPs.

Let's assume you don't want to do LEAPs and want to sell monthly to quarterly contracts. By having options laddered, you would only have a few options getting assigned to you at a time, so the cash loss would be smaller and since you are buying short term treasuries, changes in interest rate are very small indeed. If all the options go red, it is likely people will go to treasuries for safety. But if that isn't safe enough for you, then you might choose a Money Market account. Again, there is some small risk that the credit system might freeze up (like in 2009), breaking the buck, etc. So you could go to CDs in a ladder along side your put option ladder. If that all seems to complex, there is the plain old savings account and bonuses banks often pay for you putting 10-100k in savings(*). I think how you structure it is dependent on your risk tolerance vs willingness to deal with complexity of running safer systems vs desire for yield. In some sense this is all implementation details, not really related to the general concept, but hopefully that helps explain how that concern can be dealt with safely. I do get it is more complex than a buy and hold strategy, but I am assuming someone is willing to invest time (e.g. laddering treasuries/CDs, having diversified options expiring at different times) and wants higher risk for a more extreme retirement timeframe, as is premised.

(*) You have to have a margin account in this case and 25+% of your options total cost would need to be sitting in a place your broker can see them, but this is still an option. Margin requirements vary by broker and time period. During panics you might have to still move your money fast.

Edit: Added comment on margin requirements.

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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by 7Wannabe5 »

I have been experimenting with this a tiny bit. Not very successfully. Mostly I just like making myself obnoxious by buying just enough shares of a very inexpensive stock and then going as far out as possible to force a price. Because pretty clear that the boundary where my little grubby fistful of pennies can move the market is “Here be dragons” territory where you can clamber up on top of a couple empty crates and watch the wizards in their bathrobes making up the math as they go.

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Lemur
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by Lemur »

@Bigato

Just read about this strategy last night. I basically discovered half the strategy without knowing it has a name but the other part of the strategy (what your friend is basically doing) is known as the wheel. I like it...

1.) Sell cash covered put (collect premium). Repeat as necessary.
2.) Get "Assigned" [bear in mind here one should choose a stock they don't mind holding long-term]
3.) Sell covered call at least above what the previous put strike price was. (collect premium).
4.) Get your shares taken away from you.

Example:

1.) With $1,000 dollars in your account, you sell one protective put on GE for $10.00 a share and collect a premium. (You need enough to cover 100 shares per contract).
2.) If the price of GE falls below $10.00, you get assigned the GE shares. If the price stays above, you keep the premium and nothing happens. Repeat as necessary.
3.) After shares are inevitably assigned, you could sell a covered call >= $10.00 a share. At $10.00 one ultimately profits off all the premiums collected. Collect premium.
4.) Ultimately your shares will be taken away from you. Skip step 3 or sell far out of the money if you want to hold on to that stock for the long-term.

Risk: Underlying falls and you end up bag holding for a while. Another risk - this strategy is capital intensive so your money is tied up.

ertyu
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by ertyu »

The weakness here is if the stock tanks so hard that the covered call above the strike of the previous put would be too far out the money to get you a meaningful premium i presume? I mean, if this is such easy money why isn't everyone doing it? Where are the potential pitfalls?

bigato
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by bigato »

The potential pitfalls are in choosing good stocks.

In my experience, after a while you kind of get a feel for what are the range of premiums that you can risk without being called/assigned. You get too greedy and the strike will be reached. Off course this won’t work all the time the way you expect, but since you make money either way, it’s all good. As long as you play with well researched stocks that you wouldn’t mind owning.

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Lemur
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by Lemur »

@ertyu

Correct. Those are the pitfalls. OTOH, sold a covered call today on an index VTI and collected a $35.00 total premium. Unless it goes up 7% or so in 2 weeks, I won't have my shares called away. Worst case scenario, it does, I'm still selling at a significant profit to my cost basis (because I bought in over-time)...and then I could just buy back in at the market using a cash covered put and here I could afford to be aggressive anyhow because I 'want' to buy back in and normally when I'm buying an index, I'm just buying in periodically anyhow...OTOH, if I'm anticipating the market dropping, I could always just pick an even more conservative put price ...effectively holding cash but buying back in the market at a better price. Market timing but getting paid while I sit on the sidelines. This flexibility is nice...

@bigato

If one studies heavily 1-3 stocks, I think there is an edge that can be gained for getting a feel for how the stock moves and reacts to certain headlines. Of course, I would only do this on blue-chips that you know well enough.

ertyu
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by ertyu »

Lemur wrote:
Wed Mar 04, 2020 11:37 am
I think there is an edge that can be gained for getting a feel for how the stock moves and reacts to certain headlines.
Cool. You make a good case for just selling otm puts if you're interested in buying.

As to the above quote, stock moves and reacts to headlines a certain way until it doesn't...

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Lemur
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Re: Couldn't an ERE'er just live off monthly covered call premiums?

Post by Lemur »

@JCD

Realizing that volatility is in my favor at the moment when executing the 2nd half of the wheel on MSFT.

By selling this option today (that i own 100 shares of so this is covered), MSFT 03/27/2020 C $180.00, I collected a $209 premium. Used that money to buy shares in Walmart.....If it get my shares called away (which I'm fine with I bought all my shares at $165...so $15 profit per share * 100 = $1500 profit), I'll just sell a put at the $175.00 strike or so to buy back in since I want to hold MSFT in the long-term anyhow. Bi-weekly is a good schedule too because it is enough time for me to gauge the movements.

I really like this method...because you can divest short-term profits into other stock, hold cash, etc and build up other holdings. Eventually, in time, I will have WMT up to $100 a share and I can start wheeling that one.

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