Covered Call Heart

by Tyler Craig, CMT

I’ve unleashed more than a few articles on covered calls lately. And to top it off this is a strategy I’ve focused on in my weekly trading labs, especially my intro labs. One of my lab participants recently emailed me and asked why I put so much emphasis on covered calls.

Though I’ve highlighted the varying advantages in my previous posts I thought I’d add a little more insight into why I’ve cozied up to covered calls. This will be my final covered call love-fest, at least for a spell.

Investigation and Implementation

When I sink my teeth into a strategy I want to learn everything about it. I want to know what lies beneath the surface. What are its quirks, its idiosyncrasies? What makes it tick? When does it work and when does it not work?  What is the best possible approach for its implementation? The torrent of covered call centered pieces I’ve crafted over the past few months, and many discussions you haven’t participated in unless you have the ultimate pleasure of being in my lab, have enabled me to flesh out the covered call play in all its glittering glory.

So why all the attention? Because I’m a thorough knowledge seeker who wants to know how to craft the perfect covered call system. Yes, it’s a personal reason, but you all benefit as well. In my selfish quest to master the buy-write I’ve undoubtedly left golden nuggets of wisdom in my wake. Did you pick them up?

Simplicity is the Ultimate Sophistication

Credit goes to my buddy Leonardo da Vinci for that subheading. Yet a second reason why I have given the covered call so much attention of late is because it’s a simple strategy that can ease stock traders into the wide world of options. Some have referred to covered calls as the gateway strategy. There it stands at the entrance to option land just waiting to welcome you into the domain of derivatives. It’s a simple strategy, palatable for the rookies, yet revolutionary in its effect.

It eases you into option writing, cost basis reduction, probability of profit elevation, and income generation. I’m getting excited just writing about it for heaven’s sake. Best of all it beats the pants off of buy and hold in the long run.

Tortoise and the Hare

My initial exposure to Wall Street was all about active trading. Passive investing was poo pooed with prejudice. As a result I was too dismissive of share accumulation. Tortoises are shmucks I thought. I wanted to be the hare. It’s sexier, appealed to my inner greed, and like most twenty somethings it was tough to think about 10, 20, or 30 years into the future. Slowly buying shares of SPY? Pffft… Not for me.

But now, I’m seasoned. Like many sages before me I too have learned that aging breeds wisdom. The older I become the more I realize how smart old people are. Self-serving statement? Indeed. But it’s true.

Let’s go through a little thought experiment. Suppose that in addition to my rabbit approach I also threw a few bones to my inner tortoise by fully funding two Roth IRAs for myself and my wife each year. I was married in 2008 so I would have been able to fund the pair of IRAs for nine years. For 2008 through 2012 I could have input $10k ($5K apiece). For 2013 through 2016 I could have input $11k ($5.5k apiece – contribution limits were raised). All told that’s $94k invested. Now, where would I have put it? Let’s keep it simple and assume I purchased shares of SPY every year; as many as possible with the monies invested. At this point I would probably own upwards of 700 shares of SPY. Now, think of the type of cash flow generation I could score with my growing collection.

First, SPY spits off an annual dividend of $4.84 which means my 700 shares would provide $3,388 annually just in dividends. On top of that I could sell seven covered calls every month. Suppose I sold one month 30 delta calls. At the time of this writing SPY is at $192.75 and March options are one month away. I could sell the March 198 call (it has a 30 delta) for $1.80 of premium. Selling seven of those would deliver $1,260 of monthly income. Annually that’s $15,120.

Yes, that prior paragraph is fraught with caveats. First, the premium afforded by the calls each month will vary depending on market conditions (implied vol levels, primarily). Some months you’ll score more than $1.80, others you’ll score less. Second, some months you will have to buyback the calls at a loss if SPY rises too far. So, I highly doubt you actually capture the entire $15,120.

But who cares?

Even if you only captured half that you’re still looking at around $7,000 plus the $3.388 in dividends annually. Not too shabby for a tortoise approach. And I haven’t even got to how much that 700 shares would have appreciated in value over the nine years. You’d obviously be sitting on a substantial unrealized gain as well.

Don’t short change the covered call by focusing on its performance on any given month on some random stock. As you lengthen your view of how it performs on an ETF like SPY, QQQ, or IWM over years its myriad advantages become manifest. In the long run the beloved covered call looks Scarlett Johansson attractive.

Time Heals All Wounds

Successful strategies share a number of common characteristics. Chief among them is the ability to generate positive results over time. Duh, I know. But just as important is your confidence that the strategy will eventually deliver the goods. If you lack the faith that your strategy of choice will allow you to win in the end, you’ll give up when the going gets tough. You won’t have the emotional fortitude to talk yourself off the ledge in the midst of a nasty drawdown and you’ll bail on your strategy blowing your chances of profits to smithereens in the process.

One thing I love about the idea of buying SPY (or DIA, IWM, QQQ) and selling covered calls is its probability of eventual profit. Its likelihood of success is insanely high. Allow me to share a gem of a chart. Perhaps my favorite in a glorious passive investing training I’ve created over the years. The graphic comes from a Morgan Housel article I came across awhile back.

time

The graphic looks at monthly S&P 500 prices from 1871 to 2012 and illustrates the percentage of periods that earned a positive return based on various hold times. Basically how often would you have been up money over X days/months/years. “Total real market returns” means the data was adjusted for both dividends and inflation.

The takeaway is that your odds of achieving a profit when buying and holding the S&P 500 (SPY being the easiest vehicle) increases the longer your hold time. And, historically anyway, there’s never been a 20 year period where you have lost money. Now, that’s assuming you simply bought once and held for 20 years. But who the heck does that? Most mortals don’t have all the money they want to invest at once. They work hard and accumulate more money year after year resulting in incremental investments. The odds of capturing a profit are undoubtedly higher if you’re buying more shares of SPY along the way. For example, maybe you threw in $500 every month over the 20 years. The consistent buying would have generated below-average costs leading to above-average gains. I’d be willing to bet virtually 100% of every five to seven year periods you were up money using that approach.

And that’s not taking into account selling covered calls along the way. With that tactic the length of time needed to have a 100% chance of profits would be far less.

To be clear, all an underwater SPY covered call position really needs to resurface and deliver precious profit-filled oxygen is time. Turns out for Index ETF covered calls time does heal all wounds. Such a thought envelopes me in comfort during drawdowns and whispers in my ear to stay the course.

 

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