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Covered Calls: The Ultimate Guide
They can be a powerful income booster, but be careful. They come with downfalls too
You ever feel like you’re old and out of touch with society?
I feel this constantly, and I like to think I’m not that old. The kids are all vaping and listening to rap music and watching the latest from Mr. Beast on the YouTube. They should be doing the things I like, dammit.
My life these days is pretty much this meme.
I also feel this way in the investing world. My strategy of buying and holding what I view as high quality dividend stocks seems to put me more and more in the minority. It seems like everyone else is short-term trading, or buying obscure microcaps, or buying the same damn seven tech stocks.
It sure doesn’t help that dividends have been a losing strategy for months now. Hell, many Canadian dividend favourites have been falling since 2021.
One strategy many dividend investors have embraced is selling covered calls. They argue it gives them more income while taking on pretty much zero additional risk. These folks generate some pretty serious income from the strategy, too, with many reporting option income in the thousands of dollars per month.
Your author has long avoided the practice, except for a brief ownership period of a covered call ETF. I simply didn’t think the downfalls — which we’ll get to in a minute — were worth it. Besides, options are complicated, and my strategy is simple.
I also think that many of the covered call advocates are cheering the benefits while ignoring some of the downfalls.
So let’s take a closer look at the practice, including how to do it, the benefits, the downfalls, and whether I’ll start trying it for my portfolio.
What’s a covered call, anyway?
A covered call is an income generation strategy that has investors sell a call option on a stock they already own.
In exchange for receiving the premium on this call, the investor has created an obligation to sell a certain amount of shares at a certain price. Since they already own the underlying shares, the risk is that the option will be exercised and the shares will be called away.
Let’s look at a real life example. As I type this, Rogers Communications shares trade at $51.35 each. The November 17th $55 call option last traded for $0.35. An investor who sells that option will receive $0.35 per share in exchange for creating an obligation to sell at $55 on that date.
(Note: I wrote this in advance because I’m currently in Japan. Kon’nichiwa and whatnot. So these numbers are not up to the minute accurate. They were when I wrote them, however, and that’s the important part)
Once November 17th rolls around, one of two things happens. The stock will close above or below $55. If the stock ends up below $55 (which is called the strike price), then the option expires worthless and our imaginary investor gets to keep their $0.35. If it closes higher than $55, then the investor is forced to sell at that price — whether it closed at $55.01 or $800 or $888899990000.
At that point, there’s two ways to look at it. An investor can shrug and focus on the profit earned between $51.35 and $55, plus the option premium. Or they can worry about all the profit they lost out on beyond $55.
A $0.35 premium doesn’t seem like much. Multiple options exist, and option traders can get higher premiums if the strike price is a little closer to the current price. Here’s an example of the multiple options available for the Nov 17th Rogers option.
Folks looking for a little additional income would sell the $52 or $53 option, which would earn them a higher premium in exchange for a larger chance of having their shares called away.
Covered calls are probably the tamest options strategy out there. Many investors dabbling in options use calls to make bets on certain stocks, using the relatively small call premium as a way to make big bets without using too much of their capital.
For instance, let’s assume someone thinks Rogers will hit $60 in the next few weeks because something big will happen. These investors would pay $0.10 per share for the option of buying at $60. Anything above $60 represents the potential profit.
That option is basically free because the market assigns an almost zero probability that Rogers shares will jump by almost 20% in just a few weeks. It’s a telecom stock, and telecom stocks just don’t do that.
Which is a nice segue into my thoughts about options in general. Most option transactions are basically lottery tickets, and I don’t think such speculation has any place in an investment portfolio. If you want to bet, download the Bet365 app and knock yourself out. Leave the option trading to the professionals. Sorry, everyone with a few bucks and a WealthSimple account, but that ain’t you.
The pros of covered calls
There are two big advantages to covered calls — the income and the extra oomph the strategy gives stocks in a falling market.
We’ll focus mostly on the income. Covered call advocates can generate some pretty serious income with the strategy, especially if you practice it consistently.
Going back to our Rogers example, 35 cents doesn’t seem like much on a $50+ stock. But Rogers has options each and every month, so suddenly that 35 cents per month translates into $4.20 per year. Add in the company’s $2 per share dividend, and you’ve increased the yield from just under 4% to more than 12%.
It doesn’t take much work, either. I know options traders who write dozens of covered calls each month, and it doesn’t take them much longer than an hour or two.
Rogers is also kind of a poor example for this strategy, too. More volatile stocks have higher premiums, which translates into more income. Yes, you’ll more often be forced to sell in such a scenario, but this isn’t such a bad outcome, since you’re always selling at a gain.
You can even take this a step further and do covered calls on stocks that don’t pay dividends. A lot of these have fatter premiums too, meaning you can really supercharge your options income this way.
In fact, covered call advocates say the income is more than enough to make up for the downsides, and I’m the first to admit they have a point. A 10%+ yield on a blue chip like Rogers is impressive, and the stock doesn’t even need to go up to generate a pretty solid return.
The other advantage to the strategy is it can be a nice consolation prize during falling markets. Rogers shares have fallen from highs of more than $70 to the $50 range. Selling covered calls during that time would generate a return from a stock that’s falling above and beyond the dividend, which is a nice bonus. It can also help investors stay patient in poor markets, which is always a plus.
The cons of covered calls
Basically, a covered call is a choice between a small bit of upside today (the option premium) or the chance for higher upside (the share price) in the future.
Further complicating this choice is the fact the option premium is guaranteed. It’s just sitting there, just waiting for someone to take it. A stock does tend to go up, but as we all know, those increases can be pretty random at times.
This is the conundrum, and for a lot of people, the choice of income right now is too much to resist.
Remember, a lot of covered call trades end up profitable, an outcome that isn’t so bad. The Rogers covered call I talked about at the beginning of this would’ve given an investor an annualized return of nearly 8%, and in less than a month, too. Imagine being upset about that outcome.
Essentially, even the worst covered call outcome is pretty good. Holding a stock and watching it go down is less good.
But the issue is a covered call strategy takes the best outcomes and downgrades them to just a pretty good result.
One of the dirty little secrets of the markets is even blue chip dividend paying stocks can rocket higher in a hurry. They don’t even need good news to propel this move, either. Sometimes the market moves quickly higher and everything comes along for the ride.
In the last year alone — which was generally a poor one for Rogers, or at least the stock — Rogers had two situations where the stock moved by 10% in the course of a month. The first was November 4th to December 5th, 2022, when shares moved from $56.60 to $63.05, an 11% move. Shares then hit a low just below $60 in April of this year before hitting $67.16 on May 1st.
Now imagine selling a $59 covered call in November or a $62 covered call back in April. That’s some pretty significant upside you would’ve left on the table.
But, at the same time, such an argument has flaws. For the whole “missing upside” thing to be really true, it would require the investor to sell at the top, which we all know is a pretty tall order. And we must also remember that blue chip stocks don’t often have such moves. This isn’t a once per month occurrence, and if it is, it’s pretty easy to just not sell covered calls on such a volatile stock.
Nelson’s covered call strategy
Right now, my covered call strategy is nonexistent, for two reasons:
I don’t want to give up that upside, even if I know it’s a comparatively rare event
It’s a bunch of work
Let’s not sleep on option two here. Sure, the brokerage keeps track of a lot of your trades and whatnot, but it’s still work to execute a covered call strategy. It adds research time, too.
Because of those two reasons, I’m going to keep my portfolio covered call free. However, I’ll leave the proverbial door open a crack and add one scenario where I will consider covered calls.
As I’ve mentioned a couple of times now, there are a few positions I’m looking to exit. These are solid dividend payers that just haven’t delivered on any earnings growth. I’m in no rush to sell; mostly because selling stuff in a bear market is generally a poor idea. I’ll wait for the market to recover and then get rid of these positions.
I think these stocks are good potential covered call names. I’m looking to sell anyway, so I might as well extract a few extra dollars out of the position before I do. And if I miss out on that last little bit of upside, I’m not worried.
Nelson’s on vacation
As I mentioned earlier, I’m currently in Japan. The trip has been excellent so far, and I think Japan is one of the best values on the planet, too.
Vacation is a time for rest, but also a time for reflection. I’ve been spending time thinking about the future of this newsletter, including some changes I’m planning to make in the new year.
I won’t reveal what those changes are just yet, partially because I’m still finalizing some details. All I’ll say is I’m excited about the future of the newsletter, and I think y’all are really going to enjoy the slightly tweaked version.
I’ll continue posting when I get back from Japan. Next post for paid subscribers will be November 28th, and free subscribers won’t get another edition until December 3rd.