Need more yield? Try covered calls
Today, we have a special guest post from one of our other newsletters: Alpha Covered Calls. Subscribe to it here and get regular insights on how selling covered calls could double or triple your portfolio’s yield.
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Need More Yield? Try Covered Calls
When people put together their plans for an early retirement, they usually look at high dividend paying stocks and ETFs to generate income. At today’s lower yields, you can assume a 3.5% dividend yield if you value capital appreciation as well.
To make over $100,000 in annual cash flow, you’d need about $2.85 million in your portfolio.
But there’s a better way if you’re looking to scrape out some extra yield.
A covered call strategy involves selling calls against shares you already own. You get to keep the premium, but if the stock goes above the strike price of the call you sold, then your shares will get “called away”.
The most common criticism of the covered call strategy is that you are limiting the upside potential. In a raging bull market, you may be worse off selling calls if you are constantly missing out on higher gains as your shares are called away.
This is a valid point.
If you are constantly having your shares called away and are missing out on gains, then you are not managing this strategy well, and you should just buy and hold.
It’s a more active strategy than dividend investing, but I think it’s worthwhile if you know your holdings well enough to effectively sell volatility without limiting upside. After all, you can make three to four times the yield of a dividend portfolio.
In my covered call portfolio, I keep track of my miss rate, which is the rate at which my covered calls end up going in the money and I lose out on potential gains (I’ll cover this in more depth later, but just know that you can still be better off if your calls go slightly in the money if you factor in the premium you collected).
Let’s look at an example portfolio. Here is a 3-stock portfolio I put together a couple of months ago:
Of course, I’d hold more than three stocks in a $950k portfolio, but this example is just for simplicity.
I want to hold stocks that meet the following criteria:
I feel comfortable holding over the long-term
Relatively high implied volatility (IV) on calls
Share prices low enough that I can own 100 shares without being overweighted in my portfolio
The last point is important because options are only sold in blocks of 100. Amazon, for example, trades at $3,6,96. You’d need to hold $369,600 worth of Amazon shares to sell 1 call option, which would take up far too much of my portfolio.
For position sizing, let’s say I have $1m in capital and don’t want a position to be any larger than 5%. That means I can only hold stocks with a share price of $500 or less. This still allows me to invest in almost anything, but rules out companies like HubSpot, Google, and Amazon.
The biggest key here is holding stocks you like over the long-term. The stocks with the highest IV are usually very speculative. For example, AMC is not a good fit for this strategy. IV levels are very high, but I could end up losing 50% of my capital just to get a 10% yield on some calls.
The part I emphasize is that this should be a long-term portfolio that you are just scraping short-term gains from. Don’t hold any stocks that you dislike for the long-term.
Another key point: You don’t always have to be selling calls or have an open short call position.
If your stock jumps suddenly and IV spikes, you could sell calls and then buy them back two days later when the stock corrects and things calm down.
For more posts like this, subscribe to Alpha Covered Calls.