Author Topic: Retirement on covered calls + dividends?  (Read 2135 times)

ChpBstrd

  • Handlebar Stache
  • *****
  • Posts: 1020
Retirement on covered calls + dividends?
« on: May 04, 2018, 03:34:27 PM »
Please evaluate:

Investors routinely trade long-term ROI for reliability of cash flow. That's why some retirees buy treasuries yielding 2% or rent houses with an ROI under 5% when they could have bought the stock market, with a long-term ROI of 7-10%. A steady cash flow can let you retire, but the zig zags of the stock market don't pay the bills every year. Stocks can have recessions, corrections, and lost decades, but as a retiree you need steady, consistent cash flow. One can compromise the risk by diversifying stocks/bonds/etc. but this is still trading long-term ROI for reliability of returns. The end result is needing a bigger portfolio to FIRE.

Even worse, the fixed income portion of a portfolio is highly vulnerable to inflation. Stocks can at least benefit as companies raise their prices. In this sense, the more stable returns of fixed income investments = more danger.

The ideal portfolio would both (a) yield steady 4-5% cash flows even in recession/correction years and (b) maintain the growth potential of a 100% equity portfolio without the risk of having to make damaging drawdowns in recession/correction years. If one could accomplish this, withdraw rates of 5% or 6% might be possible, and one could retire years sooner on a portfolio of 17-20x spending instead of 25x.

I looked at several hedging/options strategies and arrived at the following simple strategy that seems to fit the bill. The answer is to live off the revenue from covered calls and dividends, and to never reduce the number of one's shares.

Example:

Expenses = $50k/year
Portfolio = 3400 shares of SPY (current value $904k)
Dividend yield = 1.85% = $16,731/year
Revenue from selling covered calls each month for $0.85/share at a delta of about 0.2 = 3400 x 0.85 12 months = $34,680/year
Annual cash flow: $16,731 + $34,680 = $51,411

If your covered call is assigned, as will happen 10-20% of the time at the 0.2 delta, your shares are sold for the option's strike price. You immediately buy them back and resume selling covered calls. Depending how high the market went, this scenario could result in either a loss or a smaller profit that month. You would need to maintain a cash cushion to cover the occassional situation where the SPY zooms past your strike price plus the $0.85/share you received from the call, and to cover living expenses in such months (which could occur back to back in a fast-rising market like 2017).

Alternately, you could get your stocks back by writing at-the-money put options at around $3.00-3.50/share/month until you get assigned. Note that you'd generate even more cash flow than usual in this scenario.

The above system would generate cash flow even if stocks declined dramatically or went sideways for years. It is relatively immune to changes in interest rates and maintains the inflation protection of an all-equity portfolio. Plus, it maintains the long term growth potential of stocks because you are never decreasing the number of shares controlled. It would be expected to provide a steady $50k cash flow even at about a 5.5% WR as I've shown above. In contrast, a fully passive portfolio at a 4% WR would have to be $346k bigger to produce the same income - and that involves gradually reducing the number of shares.

Thoughts?

ILikeDividends

  • Stubble
  • **
  • Posts: 210
Re: Retirement on covered calls + dividends?
« Reply #1 on: May 04, 2018, 04:51:08 PM »
Thoughts?

Interesting, but with a couple of caveats that have kept me from pulling the trigger on something like this.

1) If there's a big (10%+) correction, of course your call will expire out of the money that month.  But then what do you do the next month?  If you write another covered call with enough premium to cover your income goal, you will realize a capital loss if that 2nd call is assigned the next month.

Continuing that assignment scenario into a third month, if you then replace those shares with a covered write, you will have generated a wash sale on your 10% (or so) loss in the 2nd month.  Though, I do understand that if you, instead, sell a put, it could potentially mitigate the wash sale scenario for a month, but that would be a month that you have no upside exposure.

Furthermore, even selling puts 31 days out could still generate an unplanned wash sale if you are assigned early; probably a relatively uncommon event, but it's an event that is outside of your control.

2) Dividends and option premiums would all be taxed harshly.  It seems unlikely that you'd ever be able to benefit from a long-term capital gain.

3) Your income from options will wax and wane as volatility trends up or down.  In extended periods of low volatility, such as we've seen before 2018, it could become difficult to generate your income goals with option sales.

4) Transaction fees, while small these days, would still be another drag factor with frequent trading.

A very interesting strategy, but basically it's the tax inefficiency, consistently inefficient over the long term, that scares me most about this approach.  Second fear is that in a sustained bull run, it seems unlikely that you would be able to come anywhere close to matching the return of a buy-and-hold on the SPY.  Third fear would be a sustained bear market, where you could potentially shrink your portfolio rapidly; which, with muted upside potential, would be harder to recover from.

Suffer enough portfolio shrinkage, and the strategy then falls apart because you no longer have the assets to cover the calls needed to generate your income goals.
« Last Edit: May 04, 2018, 11:34:10 PM by ILikeDividends »

Stachless

  • 5 O'Clock Shadow
  • *
  • Posts: 96
Re: Retirement on covered calls + dividends?
« Reply #2 on: May 04, 2018, 05:00:38 PM »
Seems reasonable, though I would personally find it easier to get the income from some of the many solid dividend stocks available today.  A basket of 20 or so of consistent dividend growers gives out all the income you are looking for while keeping the upside inherent in stocks, and if properly selected would also provide 80ish % of the diversification you'd want.  Dividend growers also tend to outpace inflation.

For example, AT&T, the stock for widows and orphans, is currently sporting a dividend yield of 6.22%, Procter & Gamble yields nearly 4%, Phillip Morris yields 5.25%, plenty of REITs, etc all offer meaningful income at today's prices.  A ginornous bonus for American investors is how qualified dividends (not REITs) have a federal tax rate of 15% up to $479k.  And your first $77,201 of qualified income is completely free of federal income tax (filing MFJ)

I realize many here are down on dividend stocks in general, but they certainly do have their place and your situation sounds like it might be one of them.  Best of luck to you whichever path you choose!

MustacheAndaHalf

  • Handlebar Stache
  • *****
  • Posts: 1115
Re: Retirement on covered calls + dividends?
« Reply #3 on: May 04, 2018, 08:41:17 PM »
Stock growth is the best way to beat inflation, but a covered call option can wind up selling that growth to someone else.  Won't you lose the best months of the stock market growth if you offer covered calls?  You might review studies about how much that impacts returns before embarking on that strategy.

Radagast

  • Handlebar Stache
  • *****
  • Posts: 1065
  • Location: West of the Mountains, East of the Sea
Re: Retirement on covered calls + dividends?
« Reply #4 on: May 05, 2018, 12:04:24 AM »
1. I don't know anything about options and so far haven't been able to pick anything up by inferrence. Do you have any good not too gimmicky rahrah recommendations for reading?
2. Isn't 5% real risk free return the holy grail of investing? If it's that easy why isn't everyone doing it? Every pension plan, hedge fund, and individual should just do this to meet their goals.

ILikeDividends

  • Stubble
  • **
  • Posts: 210
Re: Retirement on covered calls + dividends?
« Reply #5 on: May 05, 2018, 01:37:59 AM »
1. I don't know anything about options and so far haven't been able to pick anything up by inferrence. Do you have any good not too gimmicky rahrah recommendations for reading?

An option is a standardized contract between two investors.

Buy a call option, and you have the right to call stock away from the seller of the option at the option's strike price, but only if the stock is higher than the strike price when you call his stock away, and you have that right only for a fixed period of time.  Hence the name, "call."  If the stock never rises above the strike price before expiration, you lose 100% of what you paid for the call.  The option ceases to exist when it expires.

Buy a put option, and you have the right to put your stock to the seller of the option at the option's strike price, but only if the stock is lower than the strike price when you put the stock to him, and you have that right only for a fixed period of time.  Hence the name, "put."   If the stock never falls below the strike price before expiration, you lose 100% of what you paid for the put.  The option ceases to exist when it expires.

An option is a contract between two investors.  One investor will win.  The other investor will lose.  It is not an equity position.  It is a zero sum game with a predetermined expiration date (expiration date is part of the terms of the standardized contract).

If you instead sell an option (either a call or a put) then you are on the other side of the contract, and you are therefore obligated to sell at the call's strike price (even if you have to buy the stock at a higher price in order to deliver it), or buy at the put's strike price (even if the prevailing price is much lower).  What you gain by selling an option is the premium that the buyer paid to buy the contract.  But that's all you get.  You will never make more, regardless of how the stock moves.

There is your no rahrah explanation.  But if by no-gimmicky, you mean simple and non-technical, then there is no simple or non-technical explanation for how to price options.

You can combine option positions with other option positions, or with stock, to take on more risk, or to reduce risk; with corresponding adjustments to potential gains.  But understanding how to do so will never be as simple an exercise as just buying and selling stocks. Option strategies are a pretty deep topic all on their own.

Quote
2. Isn't 5% real risk free return the holy grail of investing? If it's that easy why isn't everyone doing it? Every pension plan, hedge fund, and individual should just do this to meet their goals.

There is no easy way to make money with options.  Ignore any books or "Gurus" that say there are.  Run away, and fast.  You will save far more than the price of the book or the online "training" course.

With options you need to be both right on the direction of the move, as well as the timing and magnitude of the move.  You need to understand whether and when to have a long or short bias on an underlying stock--and for how long. And you need to be able to do that consistently.

Generally speaking, options are basically only suited for traders  (having some skill or aptitude in the trading arena), but definitely not appropriate for passive or uninvolved investors.

JMHO.  'Nuff said?
« Last Edit: May 05, 2018, 03:26:56 AM by ILikeDividends »

FIPurpose

  • Pencil Stache
  • ****
  • Posts: 661
  • Location: ME
    • FI With Purpose
Re: Retirement on covered calls + dividends?
« Reply #6 on: May 05, 2018, 07:41:13 AM »
I do a little bit of option trading, but really only to buy into and sell out of positions. (Ie, only selling covered puts and calls). They can be profitable, but this sounds like you haven't done enough analysis with this strategy yet. If you're really serious about it, I suggest building out a back test at Quantopian.com. But honestly, my guess is that you'll find that the few times where your stock gets called away will more than negate the benefit that you're hoping for.

Even using the risk numbers you have there:
.2 Delta means you'll be called 20% of the time
You're hoping for an extra 3-4% per year, while getting called 2-3 times.
If the market moves 15% in a month, it's gone.

If you really want to have a good steady option strategy, you can instead each year, sell 2% of your portfolio by selling ITM Covered Calls. This will give you downside protection with the premium. Overall this may decrease a 4% withdraw rate to a 3.9% withdraw if done correctly. Which isn't nothing, but also isn't a magical double your money solution. You're only making money because you were going to sell anyways.

But you have to balance this with the question: Is my option strategy just leading me to sell my stocks at worse moments? You may make a premium, but are you really just erroding the value of your portfolio?

I don't know any DG investor that suggests selling options on big ETFs like SPY. Options on individual stocks is different though. It is much easier to decide if you're long or short individual stocks, but on the overall market? No one can even begin to guess which way that beast will move.
« Last Edit: May 05, 2018, 08:14:49 AM by FIPurpose »
My journey going from partial FI to Peace Corps to the final push to full FI:
Journal

Financial.Velociraptor

  • Handlebar Stache
  • *****
  • Posts: 1209
  • Age: 45
  • Location: Houston TX
  • Devour your prey raptors!
    • Financial Velociraptor
Re: Retirement on covered calls + dividends?
« Reply #7 on: May 05, 2018, 10:18:35 AM »
I do something like this and  have for about 7 years.  Been FIRE since 5OCT2012.  You can follow my strategy and trades on my blog (see signature line). 

Thumbnail version of my strategy is to build an income centric portfolio that returns more cash than I need in retirement, preferably with lower volatility.  I am 60/40 equity (options)/bonds.  The 'bond' portion is primarily in closed end funds purchased at a discount to NAV, mostly in debt and debt like instruments.  These funds are immune to early redemption and can let duration risk expire.  The 60% equity is mostly in written puts (and covered calls when I get assigned) on individual stocks.  The individual stocks tilt heavily towards medium to high yield issues so I have cash flow if I am assigned and cannot exit with covered calls at the original strike for a "long" time. 

My withdrawal rate is around 5%.  I feel very comfortable there as my projected forward 12 month dividend, distribution, and interest income comes to 126.36% of my budget.  That is, I could take a roughly 21% cut in passive income and still not need to sell.  I make yet again over 100% in additional income from my options trades.  This strategy has so far beat the S&P 500 for 7 years running.   It will lag the market in blow off top super gaining years (I'm trading away upside for income and safety).  It is unproven yet but I expect to outperform the broad market in down years.  I am trailing the market so far this year for the first time thanks to a mis-step with a side strategy in UVXY puts.

It was noted above this strategy is NOT tax efficient.  That is absolutely correct.  I find it matters little if you are doing it on a small scale like I am (about 0.5 MM), as I have paid a negative income tax rate in 3 of the last 5 years after ACA subsidy. 

Another downside is the process is much less passive that indexing.  If you enjoy trading options like I do, this is a non-factor. 

Also, if you post about what you do on MMM, you will be labeled a heretic and a dirty, dirty market timer.  Guess how many fucks I give?

Anyway, I wanted to chime in here to note that as someone who is doing this and has done it.  In my opinion, it is mightily important to have a strong fixed income allocation.  You want to be able to say "pass" when the market is not offering any attractive premiums.  If you are forced to trade every month because you need to the cash to make rent, you will eventually find yourself picking up nickles in front of a steam roller.  The best trades you will ever make under this strategy is "no trade."

I can answer questions here or by PM if you prefer.

Also, indexing is perfectly valid too.  Go with works for you.
Achieve Financial Escape Velocity - Financial Velociraptor

bacchi

  • Magnum Stache
  • ******
  • Posts: 2795
Re: Retirement on covered calls + dividends?
« Reply #8 on: May 05, 2018, 03:21:07 PM »
3) Your income from options will wax and wane as volatility trends up or down.  In extended periods of low volatility, such as we've seen before 2018, it could become difficult to generate your income goals with option sales.

Exactly.

Like a lot of option strategies, it fails in certain scenarios. This strategy fails during sideways markets with low volatility. It also lags in very high-rising markets, which could be a problem long-term if you're continually getting called (and the capital gains would be a problem).

As far as large drops, you're possibly no worse off -- you'd have to sell low just like a b&h investor but your strategy would have to wait until the shares recover. Of course, if you have the funds to wait for a recovery, you may as well just go with a standard 4% b&h plan.


Disclosure: I do pick up nickels in front of steam rollers with a small portion of my invested assets (the remainder is indexed).

Telecaster

  • Handlebar Stache
  • *****
  • Posts: 1182
  • Location: Seattle, WA
Re: Retirement on covered calls + dividends?
« Reply #9 on: May 05, 2018, 10:14:59 PM »
Example:

Expenses = $50k/year
Portfolio = 3400 shares of SPY (current value $904k)
Dividend yield = 1.85% = $16,731/year
Revenue from selling covered calls each month for $0.85/share at a delta of about 0.2 = 3400 x 0.85 12 months = $34,680/year
Annual cash flow: $16,731 + $34,680 = $51,411

If your covered call is assigned, as will happen 10-20% of the time at the 0.2 delta, your shares are sold for the option's strike price. You immediately buy them back and resume selling covered calls. Depending how high the market went, this scenario could result in either a loss or a smaller profit that month. You would need to maintain a cash cushion to cover the occassional situation where the SPY zooms past your strike price plus the $0.85/share you received from the call, and to cover living expenses in such months (which could occur back to back in a fast-rising market like 2017).

One of the problems is the part in bold.   You can't do this with just $904K, because you need the cash cushion.  So the returns need to be calculated on the $904K plus however much cash you need.

Another problem is that let's say you go through a bad stretch and exhaust your cash cushion, or even part of it.  Now you have to replenish that cash cushion.  Where does that money come from?  It has to come out of current income, right?  That means you you can't count on spending the whole (now less than) 5.5%  Some of it has to go back to replenish the cash cushion.

Another problem is that you mentioned the calls would get assigned 10-20% of the time, but in your cash flow calculation above, you assumed they don't.  But if you assume some years the calls really will get assigned 20% of time then your income drops below 5%.   And again, you have to include both the cash cushion in your total portfolio value, and the ability to replenish the cash cushion as an expense against future income.

If you do all that, I suspect you'd be around 4%.







Inquisitive1

  • 5 O'Clock Shadow
  • *
  • Posts: 15
  • Location: Australia
Re: Retirement on covered calls + dividends?
« Reply #10 on: May 06, 2018, 01:13:53 AM »
Thoughts?

Certainly an interesting idea.

Everyone has got to find what works for them, their personality and the like. It would be great if we could use one options strategy and get the type of additional yield you mentioned but I just don't think it works quite that way.

I think in the options space one needs to identify where they have an edge over the other market participants,
CBOE recently had a good webinar on a put strategy that has merit at certain times, likely not when markets are elevated and volatility is on the low side. But after the market has had a good fall and volatility has spiked.
https://onlinexperiences.com/scripts/Server.nxp?LASCmd=L:0&AI=1&ShowKey=50447&LoginType=0&InitialDisplay=1&ClientBrowser=0&DisplayItem=NULL&LangLocaleID=0&SSO=1&RFR=NULL&RandomValue=1525587605124
 
I am 95% a buy and hold type but use options to get another 1-2% yield. I have tracked down month end historical data for MSCI indices's and backtested a heap of option strategies and use 9 different strategies at different times when history shows they have a sufficient edge. For example when the MSCI World falls >10% selling a 6m 10% OTM PUT (ETF ACWI) has a 79% success rate (expires worthless) with data since 1970. Of course lower premiums v's ATM options but a higher success rate, the eternal trade off. This strategy has only been available in 9.3% of the months in the dataset so I need more strategies. The other 8 are used at other times that show they have an edge.

Options are not for everyone but can be used effectively to generate a little extra return with care & I find it fantastic to watch time values erode. I would say perhaps have a bit more of a think about your approach and if you go ahead start off to the conservative side. In your example perhaps with 2% OTM calls rather than the ATM calls, will crimp the premiums but most likely increase your success rate and keep stock turnover lower. There are infinite strategies & tweaks but most importantly try to find your edge in the market.

Good luck
Cheers

ChpBstrd

  • Handlebar Stache
  • *****
  • Posts: 1020
Re: Retirement on covered calls + dividends?
« Reply #11 on: May 07, 2018, 10:39:34 PM »
One of the problems is the part in bold.   You can't do this with just $904K, because you need the cash cushion.  So the returns need to be calculated on the $904K plus however much cash you need.

Another problem is that let's say you go through a bad stretch and exhaust your cash cushion, or even part of it.  Now you have to replenish that cash cushion.  Where does that money come from?  It has to come out of current income, right?  That means you you can't count on spending the whole (now less than) 5.5%  Some of it has to go back to replenish the cash cushion.

Another problem is that you mentioned the calls would get assigned 10-20% of the time, but in your cash flow calculation above, you assumed they don't.  But if you assume some years the calls really will get assigned 20% of time then your income drops below 5%.   And again, you have to include both the cash cushion in your total portfolio value, and the ability to replenish the cash cushion as an expense against future income.

If you do all that, I suspect you'd be around 4%.

Yes, this would probably involve a ~$100k "assignment fund" in addition to the $900k, so yes, now we're talking about a $1M portfolio and only 5% WR. You could invest this entire "assignment fund" in equities, because the only time you'd ever need it is if equities went through the roof and deprived you of covered call income!

Re: cash flows, I ran the assumption based on the options expiring worthless each month because that is the low-paying scenario. The high-paying scenario is if the option is assigned, and I get to sell a put at-the-money to get my shares back. At today's prices, a set of calls at the 0.20 delta is about $1 per share, but at-the-money puts, with a delta of -0.489, sell for about $4.15 per share. So getting assigned means earning a big bonus the following month.

The market could outrun even that kind of cash flow in the short term, but not in the long term I don't think. If the market went on a 1999-style tear, and I chased it upward selling 3400*$4.15=$14k worth of puts per month for several months, only to watch them all expire worthless, then I think I could both pay expenses and replenish the emergency fund. In terms of cash flow, I would miss some dividends but make up for that in put premium. In terms of shares owned, the entire S&P 500 would have to go on a very aggressive extended run for me to be unable to buy back my 3400 shares with the proceeds of various assignments and options sales. Probably if things got that bubbalicious I'd just sell puts until the bubble burst and I got assigned at a lower price. 

So in summary, earning $3400/mo from covered calls 80% of months and $14k, minus any price overshoot, minus dividends 20% of months seems like a reasonable plan that should throw off extra cash to replenish the assignment fund right after those funds are needed.

Radagast

  • Handlebar Stache
  • *****
  • Posts: 1065
  • Location: West of the Mountains, East of the Sea
Re: Retirement on covered calls + dividends?
« Reply #12 on: May 08, 2018, 11:10:47 PM »
There is your no rahrah explanation.  But if by no-gimmicky, you mean simple and non-technical, then there is no simple or non-technical explanation for how to price options.
I want to see the technical part, but I always get dissuaded by a writing style that is between Dave Ramsey and a used car dealership brochure, or something salesman-y. https://www.thebluecollarinvestor.com/ turns me off at the first page.
Quote
Quote
2. Isn't 5% real risk free return the holy grail of investing? If it's that easy why isn't everyone doing it? Every pension plan, hedge fund, and individual should just do this to meet their goals.

There is no easy way to make money with options.  Ignore any books or "Gurus" that say there are.  Run away, and fast.  You will save far more than the price of the book or the online "training" course.

With options you need to be both right on the direction of the move, as well as the timing and magnitude of the move.  You need to understand whether and when to have a long or short bias on an underlying stock--and for how long. And you need to be able to do that consistently.

Generally speaking, options are basically only suited for traders  (having some skill or aptitude in the trading arena), but definitely not appropriate for passive or uninvolved investors.

JMHO.  'Nuff said?
Right. And I am not dogmatic, so if Escape_Velocity says he gets great returns trading I will believe him. I am not so sure about ChpBstrd, it seems like if there was an easy path to a safe withdrawal with S&P500 index fund options, everybody and their grandma would already be doing it. It seems as if options might allow you to pick up shares at a lower price somewhat consistently, but I haven't been able to figure out how that works (not that I tried too hard, but it still seems interesting).

ChpBstrd

  • Handlebar Stache
  • *****
  • Posts: 1020
Re: Retirement on covered calls + dividends?
« Reply #13 on: May 09, 2018, 08:05:29 AM »
There is your no rahrah explanation.  But if by no-gimmicky, you mean simple and non-technical, then there is no simple or non-technical explanation for how to price options.
I want to see the technical part, but I always get dissuaded by a writing style that is between Dave Ramsey and a used car dealership brochure, or something salesman-y. https://www.thebluecollarinvestor.com/ turns me off at the first page.
Quote
Quote
2. Isn't 5% real risk free return the holy grail of investing? If it's that easy why isn't everyone doing it? Every pension plan, hedge fund, and individual should just do this to meet their goals.

There is no easy way to make money with options.  Ignore any books or "Gurus" that say there are.  Run away, and fast.  You will save far more than the price of the book or the online "training" course.

With options you need to be both right on the direction of the move, as well as the timing and magnitude of the move.  You need to understand whether and when to have a long or short bias on an underlying stock--and for how long. And you need to be able to do that consistently.

Generally speaking, options are basically only suited for traders  (having some skill or aptitude in the trading arena), but definitely not appropriate for passive or uninvolved investors.

JMHO.  'Nuff said?
Right. And I am not dogmatic, so if Escape_Velocity says he gets great returns trading I will believe him. I am not so sure about ChpBstrd, it seems like if there was an easy path to a safe withdrawal with S&P500 index fund options, everybody and their grandma would already be doing it. It seems as if options might allow you to pick up shares at a lower price somewhat consistently, but I haven't been able to figure out how that works (not that I tried too hard, but it still seems interesting).

The most straightforward explanation I've found is here https://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/strategies.html. If that particular page is confusing, go up a level or two. There's tons of material.

Re: returns, the index $BXY represents the return on a S&P 500 covered call strategy with calls written 2% out of the money. The result is not much of a difference compared to simply buying and holding, although volatility is lower. However, when the index has its shares called away, it just buys them back and keeps selling calls 2% above current prices. In that scenario, my plan would be to collect a fatter premium by selling puts to get back into the stock. So it's not completely comparable.

Options are priced very efficiently, based largely on the stock's historical volatility. The price of an option is close to its mathematically expected value (unless you overpay, such as taking the bid price as a seller or the ask price as a buyer). Their prices are set by computers more so than humans. However, options are like insurance in that there is a premium to incentivize sellers of insurance. Implied volatility usually overestimates actual volatility, and this has been backtested.

https://optionalpha.com/members/video-tutorials/pricing-volatility/iv-expected-vs-actual-move

But this is not as much a point about total returns as it is about securing cash flow without giving up all of the benefits of equities. Using covered calls to extract a couple percent of consistent cash from an equity portfolio seems safer than selling shares in retirement. The strategy reduces volatility while throwing off extra cash while largely tracking the index.

http://tastytradenetwork.squarespace.com/tt/blog/data-covered-calls

The reason 5-6% WRs are less safe for buy-and-hold-then-slowly-sell retirees has everything to do with the steady reduction in the number of shares they own, especially during down markets. Mitigate that risk and you've got a more reliable cash flow with a higher sustainable WR.

bacchi

  • Magnum Stache
  • ******
  • Posts: 2795
Re: Retirement on covered calls + dividends?
« Reply #14 on: May 09, 2018, 09:25:10 AM »
The market could outrun even that kind of cash flow in the short term, but not in the long term I don't think. If the market went on a 1999-style tear, and I chased it upward selling 3400*$4.15=$14k worth of puts per month for several months, only to watch them all expire worthless, then I think I could both pay expenses and replenish the emergency fund. In terms of cash flow, I would miss some dividends but make up for that in put premium.

How does it work in a declining market? What happens if you're called out below your buy price? You're stuck with fewer shares.

You also haven't explained an extended market with a low VIX. Does your strategy work when VIX is 10?

You need to backtest this. It feels like you'd be whip lashed.

ChpBstrd

  • Handlebar Stache
  • *****
  • Posts: 1020
Re: Retirement on covered calls + dividends?
« Reply #15 on: May 09, 2018, 12:37:29 PM »
The market could outrun even that kind of cash flow in the short term, but not in the long term I don't think. If the market went on a 1999-style tear, and I chased it upward selling 3400*$4.15=$14k worth of puts per month for several months, only to watch them all expire worthless, then I think I could both pay expenses and replenish the emergency fund. In terms of cash flow, I would miss some dividends but make up for that in put premium.

How does it work in a declining market? What happens if you're called out below your buy price? You're stuck with fewer shares.

You also haven't explained an extended market with a low VIX. Does your strategy work when VIX is 10?

You need to backtest this. It feels like you'd be whip lashed.

In a steadily long-term declining or Japanese style market pattern, the strategy would continue to throw off cash flow for living expenses and outperform the market.

A two-month V-shaped dip and recovery is a real risk that the assignment fund would need to insure against. There is a sequence of return risk of selling a call at the bottom of the V and having it assigned as the market rapidly climbs out. The premium received from the call, plus the premium received from selling a put (after having the shares called away) might still not add up to the increase in the cost of those 3400 shares. Three points on this risk:
1) The S&P tends to rise gradually and fall quickly. It is not likely that a one-month 25% correction would be followed by a one-month 25% rebound. More likely this recovery would take several months. The timing would have to be just right to cause damage. A dip and recovery that occurred within the month would not matter if the stock was below the option strike price on expiration day. A dip followed by several months of slow recovery would not eliminate cash flow from options.
2) The call sold at the bottom of the V and the put sold to get back in the trade would bring in much more revenue than usual due to higher volatility, which increases option prices. This would offset much of the loss.
3) The potential for loss as a result of a market dip and recovery is comparable to the loss experienced by a person selling shares through the dip at a discount to cover living expenses. The difference is that a portfolio that reduces their number of shares suffers a permanent impairment, whereas this strategy could be expected to earn those shares back through higher premiums in subsequent months.

In a low-volatility environment, the 0.20 delta would occur closer to the stock's current price than occurs in a higher volatility environment. The likelihood of assignment would be similar. Cash flows would continue. A sudden increase in volatility might result in an assignment, depending which way it went.

bwall

  • Bristles
  • ***
  • Posts: 410
Re: Retirement on covered calls + dividends?
« Reply #16 on: May 09, 2018, 01:34:19 PM »
I've heard for a long time that the sucker's bet is buying front month out of the money calls. Just costs a little money, but always looses.

So, I've adopted a similar strategy to what you describe: I write front month/week, out of the money covered calls.

Usually with only one or two trading days left. If it gets called away, then just buy it back Monday morning. With the underlying stocks worth around $100k - $125k, I've been able to average $1000/mo. this year. More play money than anything else.

I'd never thought about writing puts to buy back the stock when it's called away. That's a good idea.


ILikeDividends

  • Stubble
  • **
  • Posts: 210
Re: Retirement on covered calls + dividends?
« Reply #17 on: May 09, 2018, 04:11:07 PM »
2) The call sold at the bottom of the V and the put sold to get back in the trade would bring in much more revenue than usual due to higher volatility, which increases option prices. This would offset much of the loss.
One concern, as I mentioned above, is that selling a put doesn't actually get you back into the SPY immediately.  It only potentially gets you back in at some future date, so you have no upside potential, beyond the collected premium on the put, until after it gets assigned.

However, I'm now thinking there might be a reasonably effective way to use margin very judiciously to close that objection down, depending on your broker.

Schwab (my broker) offers an SPY near equivalent, symbol SCHX (trades transaction fee free).  I'm assuming other brokers have something similar to Schwab's SCHX. 

So the only slight modification to the strategy needed is that in the V scenario, when you write a naked put, you also immediately buy the ATM dollar equivalent number of SCHX shares that would equal the value of the cost at an SPY assignment.  Now you have the put premium in your pocket, you remain eligible for dividends (on SCHX, instead of on SPY), and you still ride up with the market, using SCHX, if it takes off on you.

And if the market takes off for several months in a row, you just keep writing SPY puts all the way up, while still collecting a dividend on SCHX.  And you reap the upside rewards of a bullish move in the market, before you get assigned on the SPY puts, with the additional benefit of not having capped your reward with written calls during that period.

Eventually, your SPY puts will get assigned, and you are now on margin for those assigned shares.  You then immediately sell the SCHX position, to wipe out the margin debt, and you resume writing calls on your SPY position.  Rinse and repeat.

Seems this tweak to the strategy could also mitigate much (or at least some) of the wash-sale potential, making the strategy more able to exploit realized tax losses that you would never be able to exploit using a buy-and-hold strategy.

The tricky part is that if the market falls way below your put's strike price, you wouldn't have enough equity in the SCHX position to wipe out the margin debt entirely when you get assigned.  So this would introduce some additional risk, offset by the additional benefits, as compared with the unaltered strategy.

Possibly a stop loss order on SCHX a few pennies below the dollar equivalent of the SPY put's strike price is all that's needed to mitigate much of that additional risk. You could then adjust this stop upwards each month that you need to continue writing SPY puts.

If you get stopped out on a head-fake, but are not then assigned against the SPY puts, then you are no worse off (approximately) than you would have been without this tweak to the strategy; with the possible exception of generating a capital loss and a wash-sale on the SCHX position that you wouldn't have otherwise incurred by sticking to the original strategy.
But for the same reasons, a head-fake could just as easily generate an unexpected capital gain, depending on how many months you had the SCHX position in place.

Essentially, since you're not usually going to be out of the market for more than a weekend, there's no real urgency to swap back into SPY shares.  You could alter the strategy further to write slightly OTM puts instead of ATM puts against the SPY.  I can think of a tax scenario where writing OTM puts could be a slight advantage on the first month that you have to write the puts.

And since your upside on SCHX isn't capped by a written call, it seems plausible to suggest that you might want to keep the SCHX position on for as long as is reasonably possible, while collecting dividends on SCHX, and collecting monthly OTM premiums on SPY puts (even if slightly lower premiums than selling ATM puts) all along the way.

Volatility skew typically favors the pricing of puts over calls; which should also support a bias to keeping the SCHX trade on proportionally longer than the covered call alterntive on the SPY.  In fact, it might actually support an argument that closer to the money covered calls should be sold on the SPY, simply to swap back into SCHX shares and naked SPY puts as soon as possible.

Anything else I'm missing here?



« Last Edit: May 09, 2018, 08:27:10 PM by ILikeDividends »

ChpBstrd

  • Handlebar Stache
  • *****
  • Posts: 1020
Re: Retirement on covered calls + dividends?
« Reply #18 on: May 09, 2018, 08:23:57 PM »
2) The call sold at the bottom of the V and the put sold to get back in the trade would bring in much more revenue than usual due to higher volatility, which increases option prices. This would offset much of the loss.
So the only slight modification to the strategy needed is that in the V scenario, when you write a naked put, you also immediately buy the ATM dollar equivalent number of SCHX shares that would equal the value of the cost at an SPY assignment.  Now you have the put premium in your pocket, you remain eligible for dividends (on SCHX, instead of on SPY), and you still ride up with the market, using SCHX, if it takes off on you.

And if the market takes off for several months in a row, you just keep writing SPY puts all the way up, while still collecting a dividend on SCHX.  And you reap the upside rewards of a bullish move in the market, before you get assigned on the SPY puts, with the additional benefit of not having capped your reward with written calls during that period.

Eventually, your SPY puts will get assigned, and you are now on margin for those assigned shares.  You then immediately sell the SCHX position, to wipe out the margin debt, and you resume writing calls on your SPY position.  Rinse and repeat.
Your broker would require you to borrow to provide cash coverage for the put you sold (which technically could be assigned at any time with only hours to deliver, so assets would have to be on hand.). The interest rate on that margin would be rough. Your shares of SCHX would not be acceptable as margin.

Alternative: you could double-leverage your portfolio by holding SCHX plus S&P call options. Your downside would be limited to about 1x SCHX plus whatever you paid for the call (typically 5-7% per year). Your upside would be 2x the S&P minus what you paid for the call. 

My broker also has a commission-free S&P ETF with no options market: SPTM. Fortunately it has an ER lower than Vanguard's. I buy odd lots of SPTM (~$34 each) while I save up for the next 100 shares of SPY (~$269 each).

ILikeDividends

  • Stubble
  • **
  • Posts: 210
Re: Retirement on covered calls + dividends?
« Reply #19 on: May 09, 2018, 08:31:03 PM »
2) The call sold at the bottom of the V and the put sold to get back in the trade would bring in much more revenue than usual due to higher volatility, which increases option prices. This would offset much of the loss.
So the only slight modification to the strategy needed is that in the V scenario, when you write a naked put, you also immediately buy the ATM dollar equivalent number of SCHX shares that would equal the value of the cost at an SPY assignment.  Now you have the put premium in your pocket, you remain eligible for dividends (on SCHX, instead of on SPY), and you still ride up with the market, using SCHX, if it takes off on you.

And if the market takes off for several months in a row, you just keep writing SPY puts all the way up, while still collecting a dividend on SCHX.  And you reap the upside rewards of a bullish move in the market, before you get assigned on the SPY puts, with the additional benefit of not having capped your reward with written calls during that period.

Eventually, your SPY puts will get assigned, and you are now on margin for those assigned shares.  You then immediately sell the SCHX position, to wipe out the margin debt, and you resume writing calls on your SPY position.  Rinse and repeat.
Your broker would require you to borrow to provide cash coverage for the put you sold (which technically could be assigned at any time with only hours to deliver, so assets would have to be on hand.). The interest rate on that margin would be rough. Your shares of SCHX would not be acceptable as margin.
That's called a cash-secured put write.  That's not what I'm talking about.  At Schwab I am approved to make level 2 option trades (Schwab's nomenclature); level 3 includes naked put writing (not cash-secured).  As long as I have enough margin to cover the assignment (before liquidating SCHX), I don't start paying margin interest until I am assigned*, at which point I would sell the SCHX asap to get rid of the margin debt.  So I shouldn't really be exposed to the brutality of margin rates for more than a few days.

The non-US, non-large-cap, non-equity portions of my AA holdings provide plenty of margin to cover an SPY assignment, without relying on my SCHX holdings for margin to cover an assignment.  I do realize this aspect is a departure from the scenario described in your OP.  Large cap US equities is the largest (but slightly less than a 50%) allocation of my AA, so I think exploring this strategy has merit in terms of that one slice of my AA.

But even at just level 2 option trading, I am already approved for vertical put spreads.  So I could achieve something very similar with a ridiculously wide bull put spread, by adding a wayyyyyy out of the money long put for pennies, just to cover the near-the-money short put.

Obviously the spread would have to be secured by cash* (or secured by margin capacity*, both also assumptions), so I couldn't get too crazy with the spread there; but something manageable could certainly be employed, if I can't (or don't want to) get approved for level 3 trading.

You don't have to go absurdly far OTM to buy SPY puts to cover the short SPY puts for mere pennies.  And since a put spread (combined with a stop-out order on the SCHX position) would put a floor under your downside exposure, a wide bull put spread might actually be a better (additional) tweak to the strategy than selling either naked or cash-secured puts, in terms of reducing risk, and increasing the portfolio's optionality.

If the market falls below the strike on your long puts, you are protected (i.e., insured) at the long puts strike price.  A vertical spread allows you to precisely define your risk in advance of a market move, using bull put verticals (or bear call verticals, for that matter).

The wider the spread, the more likely you will be left owning the long put options having an inflated value, meaning you can then use the now-more-valuable long puts to leg into another put spread (either a bull spread or a bear spread, depending on your updated directional bias) by adding new short puts at a lower strike than your original short puts, but only after you get assigned early on the original short puts.

Of course you could always, alternatively, just sell the inflated long puts to partially mitigate the loss on the original short put assignment if you do not have a high conviction in the directional bias. Hmmm.

*This is my understanding, but I haven't yet called Schwab to confirm these assumptions in recent years.  And I would certainly apply for level 3 option trading approval before embarking on this strategy without using vertical put spreads.
« Last Edit: May 10, 2018, 03:09:41 AM by ILikeDividends »

ChpBstrd

  • Handlebar Stache
  • *****
  • Posts: 1020
Re: Retirement on covered calls + dividends?
« Reply #20 on: May 09, 2018, 08:50:17 PM »
I'm actually considering this alternating call/put strategy and also a collar strategy. Here's a couple of backtests. The "Put Writing" study could be said to approximate my alternating strategy because the risk profile of a covered call is the same as the cash-secured put.

Put Writing
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.458.4882&rep=rep1&type=pdf

Collar
http://www.indexcollar.com/wp-content/uploads/2012/11/2-A-umass_collaring_cube.pdf

bacchi

  • Magnum Stache
  • ******
  • Posts: 2795
Re: Retirement on covered calls + dividends?
« Reply #21 on: July 02, 2018, 10:51:08 AM »
I decided to try this strategy (#2, or the writing puts version). SPY premiums are higher than VTI so that's what I used for this experiment).

Numbers aren't exact. If it matters, I'll look them up.

Sold a June SPY ATM put for $4 and change. It expired worthless. SPY was around $274 at the time.
Sold a July SPY ATM put for $4 and change. It expires this Friday about $4 down from when the call was sold (~$274 to ~$270).


SPY is at $270. I'm +4 because of the 2 puts I sold (274 - 4 - 4) giving me an effective purchase price of $266.

Currently, I can sell an August 274 call for $3.25. I could also sell a 270 ATM put for $5.66 or a 266 put for $8.58.

Since this strategy is for generating income, it seems the 266 put is the wrong choice. Or is it?



** This is ignoring the STCG hit for each sale. **

ChpBstrd

  • Handlebar Stache
  • *****
  • Posts: 1020
Re: Retirement on covered calls + dividends?
« Reply #22 on: July 02, 2018, 01:42:06 PM »
I doubt there is a way to know ahead of time which strategy is preferable.

Writing puts is a good way to get left in the dust when the market rises faster than premiums are coming in, but it's a good way to generate income and mitigate losses if the market is flat or very slightly down (such as during your experiment). In a full-fledged crash, however, it's almost as bad as owning the stock and you'd wish you'd gone with collars instead.

The same could be said for picking a strike price. The ideal outcome is for your short options to expire barely OTM each time. At what price will that be? IDK, but you can trust that the pricing reflects the historical probability. The question is whether you're feeling bullish or defensive (which sounds a lot like market timing, doesn't it?).

I've been rotating between OTM short puts and covered calls in my IRAs and getting results similar to your experience (beating the market in June). To answer your question, check out the backtesting done by Kirk Duplesse at optionalpha.com. He recommends a sweet spot at the 30 delta based on empirical research with historic data.

https://optionalpha.com/cheap-options-115565.html
https://optionalpha.com/selling-options-96965.html

No need to swing for the fences when earning 1-2% per month at roughly the same downside risk as a buy-and-hold position.

One

  • 5 O'Clock Shadow
  • *
  • Posts: 33
Re: Retirement on covered calls + dividends?
« Reply #23 on: July 02, 2018, 07:39:52 PM »
Please evaluate:

Investors routinely trade long-term ROI for reliability of cash flow. That's why some retirees buy treasuries yielding 2% or rent houses with an ROI under 5% when they could have bought the stock market, with a long-term ROI of 7-10%. A steady cash flow can let you retire, but the zig zags of the stock market don't pay the bills every year. Stocks can have recessions, corrections, and lost decades, but as a retiree you need steady, consistent cash flow. One can compromise the risk by diversifying stocks/bonds/etc. but this is still trading long-term ROI for reliability of returns. The end result is needing a bigger portfolio to FIRE.

Even worse, the fixed income portion of a portfolio is highly vulnerable to inflation. Stocks can at least benefit as companies raise their prices. In this sense, the more stable returns of fixed income investments = more danger.

The ideal portfolio would both (a) yield steady 4-5% cash flows even in recession/correction years and (b) maintain the growth potential of a 100% equity portfolio without the risk of having to make damaging drawdowns in recession/correction years. If one could accomplish this, withdraw rates of 5% or 6% might be possible, and one could retire years sooner on a portfolio of 17-20x spending instead of 25x.

I looked at several hedging/options strategies and arrived at the following simple strategy that seems to fit the bill. The answer is to live off the revenue from covered calls and dividends, and to never reduce the number of one's shares.

Example:

Expenses = $50k/year
Portfolio = 3400 shares of SPY (current value $904k)
Dividend yield = 1.85% = $16,731/year
Revenue from selling covered calls each month for $0.85/share at a delta of about 0.2 = 3400 x 0.85 12 months = $34,680/year
Annual cash flow: $16,731 + $34,680 = $51,411

If your covered call is assigned, as will happen 10-20% of the time at the 0.2 delta, your shares are sold for the option's strike price. You immediately buy them back and resume selling covered calls. Depending how high the market went, this scenario could result in either a loss or a smaller profit that month. You would need to maintain a cash cushion to cover the occassional situation where the SPY zooms past your strike price plus the $0.85/share you received from the call, and to cover living expenses in such months (which could occur back to back in a fast-rising market like 2017).

Alternately, you could get your stocks back by writing at-the-money put options at around $3.00-3.50/share/month until you get assigned. Note that you'd generate even more cash flow than usual in this scenario.

The above system would generate cash flow even if stocks declined dramatically or went sideways for years. It is relatively immune to changes in interest rates and maintains the inflation protection of an all-equity portfolio. Plus, it maintains the long term growth potential of stocks because you are never decreasing the number of shares controlled. It would be expected to provide a steady $50k cash flow even at about a 5.5% WR as I've shown above. In contrast, a fully passive portfolio at a 4% WR would have to be $346k bigger to produce the same income - and that involves gradually reducing the number of shares.

Thoughts?

Sounds like a job to me