4- Thinking About Covered Calls

Wizards, Agriculture, and Black Boxes

I love metaphors. Pictures, too. I’m going to use them to help conceptualize covered calls.

Artificial Dividends

The first thing I thought when I learned about covered calls: they’re like a dividend that you create. Dividends are pretty slick, because they turn your shares (basically a theoretical claim on corporate profit) into an instrument that generates real income. You may have heard of “dividend investors” or “dividend FIRE”, where one keeps accumulating shares of dividend-paying stocks until they pay
out enough to replace the ole’ day job.

But what if you could make your own dividends? And what if the dividends you were conjuring out of thin air yielded much more than traditional dividend stocks? Covered calls can do that!

The first time I learned that, I felt like I had been imbued with the power of a financial wizard, privy to the secret arcane arts that normal mortals fear and revere.

When you sell a call you are, in one sense, collecting money for the “task1 ” of holding
shares. To me, this concept was stellar. Sounds too good to be true? At the time of writing this, if you own 100 shares of PFE (Pfizer) for 37.36 a share, someone will deposit 90 in your account, right now, for the right to buy the shares from you for 38.00 a share (yes, a price that is more than you paid for it) in one month.

Ruminate on that for a moment. Pause and Ponder.2

The possibilities seem endless, don’t they? Just think: every time you sell a call against shares you hold, your shares pay for themselves just a bit, lowering their own cost basis. It’s like using
your car to drive Uber and then using the paycheck to make your car payment. In fact, some people try to sell calls perpetually, hoping to eventually own shares that, over time, will have paid for themselves.

Owning assets that produce income is another big shift in thinking compared to just saving, and is repeatedly harped on in personal finance advice. . . But for me, I have no interest in managing a franchise3 or rental property.4 Also, not everyone has the six figures required for most traditional income-producing assets, and selling calls can get you started making money with your money for a much lower entry fee.5

Or, you could sell calls on a stock that already pays dividends and think of it as making…EVEN MORE DIVIDENDS!6

But we have to be more precise in our thinking; I may have misled you already. You aren’t really getting paid for the task of holding the shares and the associated risk of share price falling;
rather, you’re selling someone the option to buy the shares from you. The option itself is a contract for the future sale of the shares.

Real Estate Prospecting

Let’s make up an imaginary real estate example to explain it better. Say you own a swank abode. I personally would get a home from [Utopian Villas] and plunk it down in Ouray, CO if I had my pick of locale and domicile. 

The Utopian Villas “Denali” model…just look at that tiny living dream!
It even has a rooftop deck…whaaaaat?
Imagine all the bottle rockets you could shoot off that thing.
Lots of sun inside, too.

So, in this example, your place has big windows, a roomy kitchen, a fancy bathroom, and stainless steel as far as the eye can see…but suddenly a knock at the door. A smooth talking real estate developer is waiting on the other side, telling you that they think they might want to buy your house in a year. But they aren’t sure, and therefore aren’t willing to buy it right now.

To be precise, the real estate developer doesn’t want to buy your crib, but rather wants to buy the right to buy your crib. Specifically they tell you they want to buy it in a year, for more than it is worth now. Now, they are still going to be paying you

less than what they think it will be worth next year, because they are speculating7 and need to turn a profit.

So let’s put some numbers to the example.

Hypothetically

You bought your place for $220k 

Your place is now worth $280k

A real estate human wants to buy it for $320k next year, if and only if8 they feel like it.

First of all, the savvy homeowner will appreciate that giving someone an exclusive right to purchase your home should be worth something; after all, you are reducing the developer’s risk and providing them the possibility of making an outsized return, while at the same time constraining yourself a bit. By selling the right to buy your house at a fixed price in the future, you transfer your
potential to make profits to the speculator.

But what is that exclusive right worth? $1,000? $5,000? $10,000? A lot goes into that arithmetic!

Firstly, how much do you like where you live? Are you treating your house like an investment, or does it have more than just

financial value to you? Would you rather wait and see if the value goes up next year and sell it yourself, maybe for even more than the $320k real estate speculator is offering? Do you know of any secret problems with the house (ghosts) or surrounding area (active fault lines) that might make you want to sell and move soon? Do you think that if you are forced to move that you’ll be able to get another house that is just as valuable to you next year for $320,000? How much is it going to cost you to move? Is a tech giant going to build a satellite campus down the street and make the local economy explode with prosperity?

So you think about it, do some bickering, and decide on $12,000. You feel like an extra $1,000 a month would be nice, and since you bought the place for $220k and will be selling for $320k, you will have made a smooth $100k plus a $12,000 contract premium, which could cover moving costs and/or part of at least a down payment on a new house.

So you mock up this weird fantasy contract, shake hands, and you get a check for $12,000. Now what?

If your local real estate market doesn’t change one bit over the next year, you’ll end up having made $12,000 and won’t have to sell your house, because the developer is never going to exercise
the option and pay $320K for a $280K house.

If, however, it turns out that some tech giant actually does build a new campus near you and your locale morphs into San Francisco 2.0, your place might end up being worth $500K. In which case,
you’ll get a $100K return from your purchase price of $220k if you sold it to the developer for $320K, but will miss out on making the extra $280K from selling it yourself, post-housing boom.9

A 2-million dollar San Francisco home. Location, location, location.

Given that misfortune, you might be kicking yourself, or you might be ok with the fact that you can’t predict the future and made $100K plus the$12K contract price (take note, you’ll see this theme a lot).

Or, if the value of your home dropped to $268K, you’d break even since you made $12k in a year – in which case you’d feel pretty smart.

In the above scenario, your house would be equivalent to a stock, the future contract to sell would be a covered call stock option you sold, $320K would be the strike10 price, and the $12K would be the option premium.

So why doesn’t everyone do this, all the time? Just like when the price of the house skyrocketed in our example, selling a call “caps” your profits on the underlying stock (or other investment, such as an ETF or index fund). This can be hard for some people to handle. If you aren’t able to sell a call and let the shares go, and resist the temptation to chase profits, you may find yourself losing money trying to prevent shares getting called away.11

Initially, I was happy letting shares get called away.

Goodbye, shares. If you love something let it go.

I began to think of covered calls like a cash machine, short term investment where I could use my money to buy new shares, sell new calls, and make a % every month12 that would compound my account value to the millions in a matter of years. Seemed like a great deal to me!

But I was wrong. It’s not that easy.13 Instead of a black box that gives you money, it turned out to be more of a slot machine where you have some modicum of control.14

Harvesting

In another way, selling calls after a stock has gone up can “lock in” some profits without requiring you to sell any shares. It’s a bit like picking mint leaves from your herb garden without uprooting the whole plant. Anyone who has invested knows the eternal dilemma is when to buy and sell, and selling calls partially circumvents the decision. It allows you to make some money and keep your shares if the price of the underlying investment falls.

My very modest herb garden- catnip on the right.

All sound too good to be true? For some reason, a lot of people who have traded stocks their entire investing career have no idea how options work. This is a mystery to me, but I’m guessing it
comes from a few places: misinformed prejudice that all options are risky, a fear of the difficulty learning to trade options, or a lack of exposure.

As far as riskiness goes, there are lots of options strategies that have limited, explicitly know risk. In terms of difficulty, the math involved to trade options in the retail setting is limited to simple arithmetic.15 And as far as exposure goes, this book is here to help with that!

Next- Article 5: A Formal Definition Of Options

Previous- Article 3: Outline

  1. AKA Risk [↩]
  2. Grant Sanderson, like Sal Khan, is a national treasure. If you want to feel like you could have discovered calculus, I would recommend watching his series on it. They have stellar animations that he programmed himself, and a the dulcet tones of his smooth voice make for great narration. [↩]
  3. In my experience, numbers are typically easier to deal with than people. [↩]
  4. I did it once and it was a disaster. [↩]
  5. Specifically, the price of 100 shares of any stock with options. Although indexes like VTI and SPY can be quite expensive, there are optionable stocks
    across the spectrum of share prices. SPYG and SCHD are good, lower cost, optionable funds that track the “growth” and “dividend” subsets of SPY, and may make for a suitable, less capital-intensive alternative. There are also some optionable stocks under $5, that would make for great practice before selling options against indexes, but at that point paper trading may be preferable
    than “stock-picking” for the average Mustachian. [↩]
  6. This is just the tip of the iceberg– more on that later. [↩]
  7. This is the whole reason that options exist- uncertainty about future prices. Options distill the market’s expectations about future prices into a real number today. This area where rubber meets the road with probability is super cool and of great intellectual interest to me.

    Because options are linking the uncertain future to the certain present, they are relatively straightforward and simple instruments with a variety of functional applications.

    Options can provide outsized leveraged returns, or provide protection by using options as a kind of insurance. This book details how they allow shareholders like us to sell someone else the right to buy our shares, because selling that right generates income! [↩]

  8. To equate this example to tock options more, we will assume that if your house is worth more than $320K that the speculator WILL feel like buying it. [↩]
  9. This is known as upside risk, which we will come back to again and again throughout the book. [↩]
  10. Covered in more detail later, the “strike price” is the price that the owner of the call option has the right to buy shares at, up until the date the contract expires, regardless of what the share price actually is. [↩]
  11. More to the point, as we will see and discuss in depth later, selling covered calls is more suited to income generation than growth. [↩]
  12. Is this a bad view? Not necessarily. Treating covered calls and the underlying shares purely as a monthly income vehicle is an interesting view to take and a more difficult strategy to implement- the monthly returns are not as consistent for individual stocks due to underlying volatility and trading upside potential for premiums.
    This book essentially describes a variation of that strategy that hinges on some important differences. We use a smaller portion of our shares, with a safe index we would be invested in anyway as the underlying, with the aim of making very modest returns, selling contracts with a higher strike price that hopefully won’t result in us selling our shares. I may cover my experiences with more aggressive options elsewhere in the future, and the spoiler alert here is that it would be a mostly cautionary tale. But this is portfolio overwriting for Mustachians, not active investing for
    degenerate (just kidding) traders. [↩]
  13. Don’t believe anyone who tells you that it is. [↩]
  14. A large portion of my time spent selling covered calls was against individual securities- mostly biotech. I learned along the way that the higher premiums were often not outweighed by the added risk. After discovering FIRE, I learned that I far preferred occasionally portfolio overwriting some of the shares I plan to hold forever for some extra scratch. Most appealing was the knowledge that pullbacks were a temporary and natural part of the long-term outlook I had embraced, so it was infinitely less stressful than trying to beat the market. [↩]
  15. If you want to understand the Black-Scholes formula or binary pricing models (some of the dominant theoretical mathematical models used to price options by investment firms) in depth, you will need some higher level math…but that isn’t absolutely necessary for trading options at the retail level. [↩]