Now that you have an idea of how a covered call works, you might be pondering exactly when it would be useful to sell one against your shares.
You’re Going to Spend the Money Anyway?
A not-entirely-accurate but often provided answer is “when you would be spending the money anyway.” Say you needed to purchase an automobile for $40,000 (arguably too expensive, but it is roughly the same price as 100 shares of SPY at the time I’m writing this). Also imagine you did not have the option to lease- this is a car that your good friend bought and only drove once, but they need money now and can’t finance like a bank would. The classic pro-covered-call argument goes “rather than cash out right away, sell a covered call. You get the premium, and if shares get called away, use them to pay for the car. You still bought your car but now you have the extra premium as well.”
This seems sound at first glance— but let’s consider possible futures for a moment to poke a hole in the logic.
In a future where the S&P stays the same or rises above your strike, this makes sense.
But in a different future, there is a huge dip in the S&P. You still have to pay for the truck. Your friend needs the money, and you owe it to him, but the index tanked due to some major market
event and your shares are only worth $250 each- $25,000. Not good!
You’re Going to Spend the Money Anyway, Over Time?
So the next clever argument is “what about when you do have the option to lease? Sell a call, make the first payment with premium, and assume the entire market doesn’t crash so badly that you could afford to sell shares to make payment #2 if needed.” This argument is a bit better, but still has to contend with the fact that selling your shares outright when they were worth about $400 each would have been a better move if the index dipped to $250 per share like above.
Before you discount it, keep in mind you made a premium you wouldn’t have otherwise. And consider another future where the S&P stays the same all month, or dips and then bounces back. In these cases you made the premium and didn’t lose any index value, and you can do it again (and again, hopefully).
The point here is that portfolio overwriting wins… in some timelines. It harkens back to the fact that selling calls outperforms in down or sideways markets, but it’s not the most ideal strategy
for all situations. Nothing is. Especially if you have to sell a few shares at market-crash prices to make next month’s payment, and no longer have the required 100 shares necessary to sell covered
calls.
So how can we improve the endeavor overall?
You’re Going to Spend the Money Anyway, Over Time, but You Aren’t on a Strict Timetable?
Consider a third example, where you decided to give $40,000 to charity. But rather than a lump sum, you want to provide the charity with monthly amounts over time so they can budget with
it. The money is no longer mentally “yours”, and there isn’t as strict a timetable. In this case, it would be very nice to sell covered calls. If you only sold calls at cost basis or above, you’d know your charity of choice would get at least the $40,000 plus one month’s premium, and you wouldn’t be on the hook for something like a car payment. You could wait for the index to rebound to your cost basis before doing it again. In this case, time and flexibility are your friends.
But you may not be at the Pete Adeny1 level of giving yet. So
what kind of situation would someone have to be in where they didn’t need set income and had a sizable chunk of shares sitting around to leverage? Someone that maybe wanted to withdraw 4%
a year of some investment, while patiently holding with the other 96% forever? Someone that might like the idea of potentially NOT having to sell shares from their FIRE funds?
You probably see where I’m going here.
The perfect setup exists for someone with a frugal lifestyle and minimal expenses that is going to be cashing out at some point, but has an excess reserve of shares they can sell calls against a
portion of.
You Have the Extra Funds Available to Allocate a Portion of Your Portfolio to an Income-Producing Asset.
I need to make a very abstract, very important point here. What you are doing by selling calls is, in a way, taking a part of your portfolio and turning it into a different financial instrument. Rather than just shares that go up and down with the market, you have created a position that outperforms in sideways months, down months, or months with slight appreciation. This is the whole idea behind a hedge2 fund or diversification to an asset class like bonds, or real estate. When people reach a certain level of wealth, expanding to assets that perform well when the overall market does not is arguably the logical move. The difference with portfolio overwriting for FIRE is that the modest premiums can make a huge
difference to the frugal FIRE adherent, and it leverage the indexes you are already holding!
As far as Mustachians are concerned, this book
simply describes a side hustle you can choose to
invest some of your funds in.
It should be apparent to the reader that these conditions are the same that one would use to determine when to make ANY alternative investment- namely, when you are in a financially sound place to do so. Not exactly the most insightful and original thought, but that is how you should be treating funds allocated to portfolio overwriting- as a type of investment!
If you buy a rental house, you might not make money every month- there are occupancy issues, repairs, natural disasters etc. It’s the same thing with portfolio overwriting. In my opinion, it
should exist as a supplement, a diversification, rather than your entire portfolio.
The Best Side Hustle to Ever Exist
Speaking of rentals, I view portfolio overwriting as by far the best side hustle that ever existed. The income may be less consistent than others3 , but in terms of time spent (very little) and paucity of headaches, it can’t be beat.
- No Sales
- No Customer Service
- No Tenants asking if they can repaint your bathroom blue, which you agree to, only to find out that by “paint” they meant spray-paint with artistic graffiti (this happened to yours truly)
It’s also a fantastic way for people who may be newer to investing or have never had an entrepreneurial endeavor to see their money make money. As someone who has worked since the age of 15, the first time I sold a call and saw a premium get deposited into my account, it changed the way I saw the world. An older acquaintance4
once told me “one day you’ll wake up and realize your money can work harder than you” and it never truly clicked for me until I sold a call.
And if you do want to do a traditional side hustle, a backup portfolio overwriting fund can be a great “safe haven” cushion for that endeavor.5
Unexpected expenses can destroy businesses, especially in the early phases.6 I wouldn’t advocate for replacing your business savings and checking with an index you plan to sell shares
against, I’m just trying to illustrate that income from portfolio overwriting can be used for anything.
Premiums can also be invested into more index shares, or any other form of investments, whether it is a rental property, food truck, or something even riskier. And if those invested premiums support growth in a different area, your returns are going to be above and beyond whatever % monthly you made from the premium.
So why am I appealing to the Mustachians? Why would I plead my case to one of the most notoriously anti-active investing crowds to ever exist? Because we are perfect for it, and I’ll explain why next.
- Pete Adeny is Mr. Money Mustache’s real name. He’s given away $100,000 multiple times and described the process in blog posts, starting with one in
October 2017. As far as I’m concerned that makes him a G-D national treasure and inspirational role model we need. We have enough people showing off the material things you can buy with money. I have a fantasy in my head of convincing MMM to set funds aside and try making contributions with premiums generated from covered calls, but more likely than not I’d probably
receive a patented Mr. Money Mustache Facepunch for advocating any kind of active investing. [↩] - 2It “hedges” your bets (portfolio holdings). [↩]
- When portfolio overwriting, you only sell calls with a strike price above your cost basis, and if the market tanks you may have to wait until the share
price of your index recovers back to the point where a strike price above cost basis gets you a substantive premium. [↩] - This gentleman was a trader by profession, and was offering me advice before I knew how valuable it was. Unfortunately I didn’t properly value the
opportunity at the time, but I thankfully retained this lesson. To give you an idea of how old-school and experienced he was, he used point-and-figure charting, a very old and now obscure method of “technical analysis” where you try to predict the moves of stock by studying the past moves- the “shape” of the chart. [↩] - A dissenting opinion that I hold: Traditional finance would balk at a haven of invested funds set aside for the express purpose of supporting a business venture. Not only would it be a gross example of unutilized capital (money that could be invested in the business to generate more profits), it would be an indication that the business itself was unprofitable. I personally think this type of efficiency maximization lacks any higher order reasoning, only thinking in the numerical accounting dimension. Although this seems a common sense diversification to an uncorrelated asset to me (selling widgets and investing some of
the widget profits into an income producing investment in case a pandemic or something similar slows down your widget sales), the same people that would tell me I’m wrong would likely have taken classes in modern portfolio theory and diversification, remaining blind to the parallels. [↩] - It happened to me with my brief, disastrous foray into owning rental properties, which is one of the main reasons I prefer portfolio overwriting to real estate. Had I been portfolio overwriting at the time, I could have floated my property’s mortgage payments during times of vacancy and repair costs with call premiums rather than having to end up selling the property, at a loss, only to watch it appreciate about 700% (gentrification) from the price I unloaded it at. See above footnote. [↩]