The Benefits of Selling Covered Calls and How To Reduce Risk of Share Ownership
I regularly bang on about the income-generating benefits of selling covered calls and cash-secured puts. It’s easy to focus on the double-digit annualised yields that can be achieved with very little effort. However, there is another benefit to selling stock options that may not be quite as apparent. And that is, selling options on the stocks you own, can greatly reduce the risk of share ownership.
In fact, it is quite possible to dig yourself out of a losing share position and actually turn a dud into a winner. Try doing that with a ‘buy and hope’ strategy.
I don’t tend to focus on the P/L of my positions on any given day. That is partly because they are long-term campaigns and so the short-term gyrations of the share price are of little consequence.
But primarily, it is because these are income trades. I’ve bought an asset (the shares) at a good price and are now receiving income from that asset via the covered call premium and dividends. The value that the market subsequently assigns to those shares is of less interest because I cannot use it as income.
However, I do appreciate that most folks are used to seeing the unrealised P/L of their positions whenever they look. That’s how most folks perceive the risk of share ownership. So let’s apply that approach to a few of my recent campaigns and see what it can teach us about looking at the whole campaign.
First, a campaign where the share price has gone nowhere. Let’s take EasyJet as an example.
Back in December, for the regulated service I run, I spent £10,800 on 1,000 EZJ shares. They are currently trading at 1,080p each which means that the overall value is still £10,800. That’s an increase of sod all and reflects the profit you would have made if you had simply bought the shares.
However, because I focus on income stocks, we can add in the £586 worth of dividends we have received and that boosts the paper profit to 5.4%.
But the key differentiator between myself and a regular buy-and-hold investor is that I also sold a year-long OTM covered call on the shares and that reduces the risk. It’s not the most profitable call I could have sold, but it was a simple single transaction.
That brought in an additional £750 to add into the pot. So, between the dividend and the call premium, we have a total unrealised profit of £1,336 on the campaign.
And that equates to a paper profit of 12.4% exc. commissions and stamp duty. That’s pretty good and reduces the risk of share ownership.
Okay, what about one of my positions where the share price is underwater. Let’s have a look at Aviva.
I initially bought 2,000 Aviva shares in April 2018 for £10,640. At their current value of 414p each, the shares are worth £8,280. That equates to an unrealised loss of 22.2% — not great and it illustrates the short-term risk of share ownership.
Over the period that I’ve have owned the shares, I have also received dividends totalling £600. If you want to include that in the calculation, then it reduces the unrealised loss to £1,760 which equates to a paper loss on the position of 16.5% — that’s a bit better.
However, I also sold 2 long-term OTM covered calls for a total of £520. That can also be used to offset the loss even further and brings the total unrealised loss on the campaign down to £1,240 and that equates to a loss of 11.7%.
That’s not ideal, but it is half the loss on the share price alone. And that is what most commentators focus on. The risk of share ownership has been drastically reduced.
Indeed, this aspect of selling covered calls on dividend-yielding shares is perhaps the most compelling part of the story. There are a number of benefits for selling covered calls to reduce the risk of share ownership. Even if the shares themselves behave badly — and some always will — the income we receive can substantially reduce that loss.
And crucially, I’m not finished with the Aviva campaign yet. Over time we will add extra dividends and options premium into the mix. That will further reduce any unrealised loss on the shares themselves.
In the long run, it is quite possible to sustain a loss on the shares but for the overall campaign to be profitable.
Now that’s a neat trick and we pull it off repeatedly at FIRE Revolution. Now isn’t that a great way to reduce the risk of share ownership.
Third Friday Ltd are not regulated by the Financial Conduct Authority and the FIRE Revolution training programme is purely educational in nature. Under no circumstances do we provide any financial trading or investment advice. Any examples used are for educational purposes only and should never be construed as advice. We accept no responsibility for any investment losses you may incur. Please consult a financial advisor or other qualified professional if you are in any doubt as to the suitability of the strategies we teach.