As with anything investment-related, see my disclaimers. This post deserves an additional disclaimer. Investing involves risk. Trading stock options is extremely risky and you can lose 100% of your investment. My story is provided solely for entertainment purposes and in no way do I recommend doing what I did. Or anything else, for that matter.
As with anything investment-related, see my disclaimers. Investing involves risk. My analysis is provided solely for entertainment purposes and in no way do I recommend any course of action. Don't trust random idiots like me on the internet for investing advice. Or for anything else, for that matter.
To date, I’ve kept my covered calls experiments to my shares in Dumpster Fire, Inc. By selling these calls, I’ve traded future blowout returns for down-side insurance and income generation. I’ve also used it to ease out of my position in DFI, something I had a hard time doing on my own because of psychological traps.
Recently I started wondering if I should extend my experimenting with covered calls to my other ETF holdings, particularly in my retirement accounts where I’m not penalized tax-wise for short term capital gains on the option profit.
Benefits of Covered Calls
There are many benefits of covered calls contracts.
I keep both the security and the contract premium when the contract expires out-of-the-money. My shares are generating additional cash instead of just sitting around.
I keep dividends on unexercised options. Until the option is exercised, I remain the owner of the shares and get to keep any dividends.
Covered calls provide downside insurance. If I sell a covered call for $.75/share on a security currently valued at $15/share, I don’t start losing money until the price drops below $14.25. The call premium is a downside insurance policy, of sorts.
Being exercised out of a position could provide a rebalance opportunity. If I sell the option far enough out of the money and it ends up expiring in the money, it’s possible that I would have wanted to sell it anyways to rebalance my position. I concede this is a weak benefit.
Drawbacks of Covered Calls
I’m limiting my profit. If I sell a contract for a $.75/share in premium and a strike price of $15/share, if the price of the security zooms up past $15.75/share (i.e. in-the-money) to $17/share, I don’t benefit from the movement from $15.75 to $17. I traded away potential upside in exchange for premium and downside insurance.
Brokerage fees and spreads. At Fidelity, I pay $.60/contract, and at Vanguard, I pay $1/contract. I have to pay this fee when I sell the covered call. If I choose to exit the position before expiry, I have to pay it again if I’m using Vanguard. There’s often a bid/ask spread which especially bites if I try to exit a position early.
Having to sell shares when I don’t really want to. I’ve been intentional about the ETFs and securities in my portfolio. If a position is exercised away, I either have to pay more to return to my desired allocation, or wait for it to fall back. Either way, I risk being out of an ETF that I actually want to stay in.
My shares are encumbered. By selling the covered call, I can’t move or sell the shares until either I buy the option back to close it, or the expiration date comes and goes. I’ve typically found this to be a minor annoyance.
Tax loss harvesting interference. By giving up control of the shares during the contract, it’s possible that an exercise/sell could happen at an inconvenient time, triggering a wash sale. So I’ll have to keep track of when I trigger a loss harvest.
Example Covered Call Scenario
Let’s take a look at an example. I have over 1,400 shares of VWO in my tax advantaged accounts.
When I started evaluating this in May of 2021, VWO was selling for $53.50/share. A call with a strike price of $57 expiring on September 17th, 2021 was trading for $.65/share. By selling calls against all of my shares, I immediately collect $.65 x 1,400 shares = $910 in premiums. That leaves me with three outcomes on expiration:
- VWO is below $57. I get to keep the shares and sell more call options to collect more premium.
- VWO is above $57 but below $57.65. My shares of VWO will be sold but I can immediately buy them back, using the premium I received in May.
- VWO is above $57.65. My shares of VWO are sold and I lose out on any gains above $57.65. If I want VWO in my portfolio (and I do), I’ll need to buy my shares back for a higher price. I would have been better off holding my shares and either not selling calls, or selling them further out of the money but for less premium. While I haven’t lost money, I haven’t gained as much as I could have.
A few observations:
- What’s the likelihood of VWO being at $57 in September? It would need to rise 6.54%, or over 19% annualized. Can that happen? You bet!
- Let’s say that VWO is just above $57 and my shares get exercised. I immediately buy them back and then sell more options, this time at a strike price of $60 or $61. This is pretty significant volatility and chances are good that the premium is going to be at least $.65, and possibly even higher. The premium I collect can help me catch up on the gains I missed out on previously.
- If I repeat this quarter after quarter, will VWO zoom up >19.15% each time? Probably not, but who knows with my luck! I’m really liking my chances of collecting premium and getting to keep the shares at least some of the time.
A couple weeks ago, I checked in on VWO. It was trading at $53.55 and the options I’d sold for $.65/share were now selling at $.55/share. I could have bought them back and netted $140 for about six weeks of putting my shares to work.
Okay, please poke holes in my idea. I’m seriously considering it. I’ll probably start small, selling blocks of 400 or 500 shares and staggering my expiries throughout the year to reduce the risk of being completely out of a position all at once. I’m not really in it for the downside insurance, since I plan on holding these for the long term. It’s the capping of my upside that has me most worried.
Thoughts? Questions? Want to rant about how dumb of an idea this is? I’d love to see it in the comments!