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INTEREST RATES HAVE been low for years, with 10-year Treasury notes now yielding some 1.4%. How about dividend-paying stocks instead? Many pay twice what Treasurys currently yield, though obviously with more risk. My strategy: Instead of a classic 60% stock-40% bond mix, I’ve landed at roughly 70% stocks, with another 15% to 25% in individual stocks against which I’ve written call options.
By selling call options, I give the buyers the right to purchase the underlying stock from me at a specified price—the so-called strike price—at any time between now and when the options expire. Today, on my dividend stocks, traders might pay a 3% to 5% call premium for an “at-the-money” call option expiring in as little as 60 to 90 days. An at-the-money call option is one that’s sold with a strike price near the current share price, so both the option seller and buyer know there’s a decent chance the option won’t expire worthless.
That 3% to 5% premium strikes me as generous for such a short period. Put another way, I’m getting paid a 3% to 5% return to provide traders with the chance to purchase my shares at the current stock price for perhaps the next three months. In the meantime, I should also collect a dividend, increasing my return by another 0.5% to 0.8%.
If the stock price is above the strike price on the exercise date, the option’s buyer exercises the option, calling away my shares and paying me the strike price. Since the market has generally been rising, the majority of my call options have been exercised and the stocks called away. Still, I earned the call premium, plus one dividend payment, providing a 4%-plus return over three months or less—not bad on an annualized basis. If a stock rises only slightly above the exercise price, I generally repurchase the same company’s shares and then sell new call options at the marginally higher price.
When the share price is below the strike price on the exercise date, the options expire without being exercised. That means I’m left holding the lower priced shares. But the companies involved still pay solid dividends, plus I already pocketed the 4%-plus return. In these cases, I generally sell a new call option, either at the old strike price, which earns me a somewhat lower premium, or at the new lower share price. I’ve sold call options on the same shares up to three times during a year. In all but a very few cases, the option premium combined with the dividends have far outweighed any decline in the stock’s price.
I’ve written call options against stocks from a host of market sectors, including insurance (Prudential Financial, MetLife), health care (Pfizer, AbbVie, CVS Health), banking (Bank of America, JP Morgan Chase, Truist Financial), retail (Target, Home Depot), industrial (Nucor, General Dynamics, Automatic Data Processing, Archer Daniels Midland) and even some technology stocks (Qualcomm, Seagate Technology, Texas Instruments, Cisco Systems, NetApp). Some of these companies are “dividend aristocrats” that have increased their dividends for decades.
The obvious question: Why don’t I simply increase my portfolio’s stock exposure to capture the market’s gain, while accepting low bond yields on the balance? The partial downside protection offered by covered calls, coupled with the healthy dividend yields, have given me the comfort to keep more of my money in the stock market. Simply put, I prefer the risk-return tradeoff of these covered calls over low-yielding bonds, plus bond prices could get hit hard if interest rates rise.
Writing covered calls isn’t a get-rich-quick scheme, plus it takes work to keep resetting the covered calls. Moreover, in selling call options, I limit my portfolio’s upside potential, while still suffering any price declines. But such price declines are a risk that all stock investors face—and mine are at least partly offset by the option premiums I collect.
John Yeigh is an author, speaker, coach, youth sports advocate and businessman with more than 30 years of publishing experience in the sports, finance and scientific fields. His book “Win the Youth Sports Game” was published in 2021. John retired in 2017 from the oil industry, where he negotiated financial details for multi-billion-dollar international projects. Check out his earlier articles.
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John, I had the same thought process as yours many years ago. You do mention briefly the loss of the upside when a stock rises above the strike price and is exercised. I tracked my total return(including the lost upside while holding the option until it was called) vs a buy and hold. What I found is that, ex commissions, the total lost return on the upside matched the total premiums I had pocketed on the call options – the insurance premium if you will. My conclusion after several years of this was that the market, both stock and option, was pretty darn efficient. I was spending a lot of effort writing and tracking the options to wind up at the same point as a buy and hold. I just plain wasn’t smarter than the market. My next thought step was is if holding individual stocks and writing calls wasn’t better than buy and hold and teh market was so darn efficient, might as well just buy index funds and diversify more with less work – where i am today. I was Boglefied
I looked at the very few option writing funds, so this is a stock picking exercise. Seems reasonable to do this by writing calls against index ETFs. Probably not as much income or total return but lower risk.
Mark – Abolutely correct. Selling covered calls against the S&P 500 (SPY) is less risky and far easier, but you’ll be rewarded less for the reduced risk. Ninety-day-forward, at-the-money calls have been averaging about 3% in recent months which is typically 1% lower than on individual dividend stocks. In addtion, the annual S&P dividend yield is 1.3% which is half or less that of many of the dividend stocks. Still, calls on the S&P paying 3% over 90 days (this morning ~3.8%) is a comforting bond surrogate.
Thank you Mr. Yeigh. I’ve also employed this strategy over the years. In fact it worked great for me in March/April of 2020 during the market rout. At these market levels, another concern when my stock gets called away is what to do with that new cash. No bargains out there to try it again. Oh and I presume you write these covered calls in an IRA type account so the short term gains and trades are a non-event from a tax perspective?
You are spot-on in all your assumptions:
1) With the stock market rising, I’ve had to lower my acceptable dividend thresholds – I started with stocks having 3.5-5% dividend yields, but now many are at 2-3.5%. To de-risk the frothy market, I’ve recently expanded to sell some calls with the strike price “in-the-money” – the risk and returns are both lowered.
2) Covered calls worked especially well during the March to May 2020 downturn with call premiums sometimes as high as 8-10%. This de-risked the concerns of staying invested.
3) I mostly utilize this approach within IRA’s because a) the tax accounting is annoying within a taxable account, and b) most of my investable assets are held in IRA’s rather than taxable accounts.