Sale of covered calls (“covered call strategy”)

[dividinde]

I would be interested to know if any of you are trying to increase your passive income by selling covered options on stocks you already own in your portfolio.

This seems to me to be quite interesting in the case where you own a stock that has already performed well and you would have no regrets about selling it, but you also plan to keep it while generating more income than with just the dividend.

What is your opinion? What are your experiences? Advantages and disadvantages?

I have not found a Swiss site that goes into this subject in depth, here are some explanations found on foreign sites:

 

https://www.binck.be/fr/academie/nouvelles-boursieres/article/tips-analyse/call-ouverts-comment-accroitre-le-rendement-de-ma-position-en-actions

 

Covered Call Writing: A Complete How-To Guide

[Jerome]

Hi bro. I have tried to get interested in options several times in the past. Several readers, including Paul Marcel from Celtinvest, also talked about it here at the time (he was more oriented towards selling put options). Apparently some have good results with these strategies.

However, as much as I am comfortable with financial ratios, the jargon and concepts related to options seem to me to come from another galaxy. I need to understand the mechanisms of an investment before getting started and from this point of view options seem too nebulous to me. But it is possible that one day I will change my mind. I did it for gold and Bitcoin…

[dividinde]

Thanks bro for the tip. I found a brief but fairly clear article from Celtinvest on the subject: https://celtinvest.com/vendre-option-call/

I will try to dig a little deeper into the subject. For now I understand the general mechanism but not all the subtleties yet. I also tried to place a fictitious sell order on PostFinance with calls on Nestlé, but it does not work, even though I own more than 100 shares. I do not see what I am doing wrong...

[frouzback]

Hi,

I worked for 5 years in investment banking in pricing of equity derivatives… before leaving the world of finance in 2010.

My experience with these products offered to individuals (calls / puts / others) is that it massively enriches the person who sells the product and that it leaves almost no chance for individual investors to achieve a decent performance in the long term. You can of course make a "hit" here and there; but the odds will be against you and in the long term it will end up being felt.

The subtlety (= the scam) in the product you describe (selling a call when you already own the stock) is that the call you sell will be sold for a price that is far too low. You can see this by trying to buy a call instead (and there, strangely, it costs much more than the price at which you are offered to sell it).

To know what a call should be worth, we have to make an assumption about the volatility of the stock. The more volatile the stock, the more expensive the call is, basically. By selling the call at too low a price (which is what the site suggests), we say that you are "selling volatility" too cheaply. It's a bit abstract, but you should know that in finance, you can really trade "volatility" like you would trade tomatoes.

The site is therefore just looking for suckers (sorry for the term 🙂 ) to sell them cheap volatility; knowing that they can resell this volatility to others for much more; so as to win every time. It's a good business for an investment bank; but much less for the client 🙂

So I advise you to move on 🙂 Holding shares for real, directly, and over the long term, and collecting dividends that come from a real profit in the real world, that remains and will remain the solution for the little guy (=us) to avoid being eaten up by finance professionals who are ever more imaginative in their marketing.

 

 

 

[Jerome]

Hello frouzback,

Thank you for this email from an enlightened professional! It doesn't even surprise me and I always thought that the opacity of these products, as is too often the case in finance, was designed to enrich its issuers.

Finance doesn't need to be complex to work. Quite the opposite...

[dividinde]

Thank you Frouzback for this very clear feedback. Your experience in the field is valuable and reminds us that derivative products are created above all to enrich banks and not their customers.

I understand what you are saying and that the biggest problem with options is the spread between the bid and ask price is too high, which means that the call is sold at too low a price, corresponding to an underestimated volatility.

I am no longer interested in buying options (I lost enough feathers there about fifteen years ago). Selling covered options is, on the contrary, a very defensive strategy and which seems to me to allow you to receive passive income in addition to dividends. The main risk is having to sell your shares, but it is not dramatic since you can always buy them back later, or other shares offering a higher dividend.

Even though this strategy is not without its flaws and the spreads reduce the premium received, don't you think that it still allows you to do slightly better than simply holding shares, while reducing the volatility of the portfolio?

[jm4275]

Good morning,

I have been selling covered calls on stocks in my portfolio for several months on IB.

As Dividinde writes, this adds income to dividends, and in my opinion for low risk and effort.

My principles:

– work with major stocks, so that liquidity ensures a low spread

– sell a call above the current price; choose duration (expiry) and strike to obtain a premium of approximately 1% of the stock price

– sell a number of calls corresponding to part of the position (I do not want to completely lose the possibility of capital gain if the price soars before maturity)

– if as the maturity approaches the price is above the strike, but I want to keep the securities, I “roll” the position; i.e. I buy back the call, and I sell another one at a later maturity (at the same strike or higher, depending on the case); most often, I choose the new call so that this operation generates cash for me.

I haven't done a precise calculation of yield or drop in volatility, but at a guess it brings me a few percent per year, with a higher "payment frequency" than the annual dividends of Swiss stocks 🙂

[dividinde]

<p style=" »text-align:" center; »>Fantastic, thanks jm4275 for this information.</p>
I have been studying the subject thoroughly for about 2 weeks in order to form my own opinion, but I must say that the more I learn about this strategy, the more I see very positive elements in it.

Despite some reservations about spreads and volatility described by Frouzback, I am currently doing simulations (paper trading) with low-volatility blue chips and my calculations are showing very interesting results so far. With Novartis, for example, I can get spreads of 7 cents depending on the volatility and the time of day.

Could you please give me more details on the following points:

1. Expiry: Do you favor 1 or 2 month expirations?

2. Strike: you are talking about strikes above the price (out of money OTM): in general how many % OTM do you work at?

3. Premium of about 1%: I guess this is what you are aiming for for a 30 day maturity?

4. Do you wait until you are winning on the underlying (the stock) before selling a covered call, or do you also do it on slightly losing positions?

5. Do you take into account the delta when choosing the option, such as 0.3 or 0.1?

6. Do you place market or limit orders?

Thanks in advance!

[jm4275]

Good questions, which make me understand that I don't have a systematic 100% approach.

In fact, I am looking for a compromise between the premium received and the risk of being assigned because the price rises before the expiry. The trends are simple, extending the expiry increases the premium, raising the strike lowers the premium; but the compromise is an individual choice…

Regarding your questions:

1) and 3) I use expirations of 1 to 3 months, rarely more. I aim for a premium sufficient for the sales costs (1.55 CHF per contract at IB) to be negligible in my eyes and for the amount to be "worth it". Typically, a premium of approx. 1.- (i.e. a contract value of 100.-), which is about 1% of the value for Novartis and Nestlé. But it is different with stocks with much higher prices (e.g. SwissLife) or lower prices (e.g. UBS).

2) and 5) I use delta to choose; even if it is not 100% exact, I understand delta as the probability of being assigned; 0.2-0.3 (20-30% risk of assignment) is my target value, but that I modulate based on "how much I want to hold the stock". For Novartis, right now, it would be the 82 call for May.

6) Limit orders, roughly halfway across the spread; liquidity is sometimes low, so the order may take time to be executed.

4) No limit on this, but it will influence my desire to hold the stock; selling a covered call can help a losing position get back into the green more quickly, but obviously one should not let oneself get carried away by holding something that would be better sold.

Some other points:

– in periods of high volatility, all option premiums are higher, and selling a covered call is more attractive

– check if there is a dividend distribution before the expiry; this influences the premiums, and there is the theoretical possibility that the buyer of the option exercises it to receive the shares and their dividends (this is only likely if the price goes above the strike, and the option becomes in-the-money)

– check the contract multiplier; it is 100 most of the time, but sometimes 10 (e.g. Swisscom, Zurich Insurance, Geberit)

– with the premium received, we can buy the underlying asset, which increases the position “almost for free” (this is not true, since we could do something else with this money, but that’s the impression it gives me)

– if assigned and wish to buy back, it is possible to sell a put; this becomes the “wheel strategy” that yakari1400 spoke about in another post (https://www.dividendes.ch/forum-2/topic/trading-pro-et-situation-fiscale/).

[dividinde]

Many thanks for your answers. I thought that the lot size was always 100 for Swiss stocks. This is very good news for stocks like Swisscom, it is still easier to have to hold 10 (4800 fr) rather than 100 (48000 fr)! Too bad however that the size is 100 for Roche.

Regarding the maturity, I have read several times that the ideal is 1 to 2 months (more precisely: 30 to 45 days), because this is where the decrease in the time value of the premium is the most marked (exponential and not logarithmic decrease). This is why, although an option that expires in 2 months yields a higher premium than the one at 1 month, the annualized return is higher with the 1 month maturity than 2 months (in other words: the premium of the 2 month call is not 2x higher than that of the 2 month call).

The more I learn about the subject, the more I understand that the choice of strike is really the deciding element. As written above, the choice of expiry is much simpler and more logical.

What determines the choice of strike, in my opinion, is above all the question of whether one wishes to try to keep the underlying asset or sell it at a profit.

I will take the example of Novartis with these two cases to illustrate my reasoning:

——————

Situation 1:

I buy today (12.03) Novartis at 78 fr. I am willing to keep the stock in my portfolio for a long time, but selling it as soon as possible with a gain of a few % also suits me very well.

I choose to sell a call that expires on 16.04 (in about 1 month) with an OTM strike at 80 fr. I immediately receive a premium of 0.80 (80 fr for each lot of 100 shares), i.e. a return of about 1% (12% annualized).

If at maturity Novartis is trading at less than 80 francs, I keep my shares (and of course the premium collected). I can then sell a new call, and so on until my shares have been assigned.

If Novartis is worth more than 80 francs at maturity, my shares are assigned and sold at 80 francs. I have earned about 3.5% (2.5% on the share + 1% premium).

——————

Situation 2:

I bought Novartis some time ago at 75 fr. The stock is now worth 78 fr and I am currently earning 4%. I think the stock no longer has much upside potential and I am ready to part with it at this price, but would like to increase this gain thanks to the premium.

I sell a call with the same expiration but choose an ATM strike price of 78 in order to maximize the premium received. I immediately receive the premium of 1.68 (168 fr per lot of 100 shares).

If Novartis costs less than 78 francs at maturity, I keep my shares and I have gained around 2.2% thanks to the premium (around 26% annualized).

Otherwise, my shares are sold and I have earned the same premium in addition to the 4% gain on the stock.

——————

Can you follow my reasoning or do you see things completely differently?

Another question: have you read a book on the subject? I heard that Alan Ellman's books are often recommended, but maybe you know of others?

[dividinde]

Oops, I wrote a little too quickly without proofreading: regarding the erosion of the time value (theta) of the premium, I meant to write "logarithmic and non-linear" and not "exponential and non-logarithmic".

[jm4275]

Indeed, the decrease in time value accelerates as the maturity approaches, and in general the premium for a 60-day call is less than double that of a 30-day call. I have sometimes seen exceptions, for strikes several % above the price and if there is a dividend payment between 30 and 60 days. But fundamentally, it is better to favor a short maturity and repeat the operation (if the costs do not eat the difference).

Your two examples are telling and illustrate well the different goals that can be set by selling covered calls. And it is the goal that guides the choice of the call to sell!

I don't have a book to recommend, I only trained on the web; I found https://optionalpha.com and https://optionstradingiq.com/the-wheel-strategy/

[frouzback]

hello,

Sorry I'm replying a bit late.

I'm trying to answer this:

"I am no longer interested in buying options [...]. Selling covered options is, on the contrary, a very defensive strategy and which seems to me to allow you to receive passive income in addition to dividends. The main risk is having to sell your shares [...]

Even though this strategy is not without its flaws and the spreads reduce the premium received, don't you think that it still allows you to do slightly better than simply holding shares, while reducing the volatility of the portfolio?

 

In my opinion, even if you are on a strategy where you own the stock on which you sell a call; you have to ask yourself the question of the relevance of this call sale; which is therefore a short sale. You are "short call". You have to forget for 1 minute that you own the stock that goes behind and just look at this "short call" position.

When you are short call, and you have sold this call at too low a price (this is NECESSARILY the case, since these products are very very margined); the problem is that the premium that you collect will not compensate, on average, the (potentially large) loss that occurs when the stock rises a lot.

Because it is indeed a loss 🙂 Depriving yourself of the strong rise of a stock is a loss, even if it is less painful when you own the stock in addition. My argument therefore does not go further than that. Owning the stock alone is better than owning the stock + shorting a call at a price that is too low.

The premium collected will be on average too low to compensate for the unexpected super increases in the stock. You have to see that being deprived of a real "big increase" that is really unexpected in a stock is perhaps rare; but it can compensate (negatively...) for a huge amount of premiums that you will have collected. So even if you mess up in let's say 10% of cases, there is a chance that these 10% of cases will make you lose money overall, while your strategy was a winner 90% of the time 🙂

For Novartis (I am also positioned on it!) since there has not been a great rise for a few years, it would certainly have been profitable to sell calls. On a few others, it would not have worked well, however, especially in 2020. Afterwards, maybe some investors manage to predict very, very consistently which stocks will rise, but not too quickly 🙂 Novartis could be a good candidate for your strategy; but the problem is that this characteristic (stock that rises very slowly) is generally reflected in the volatility of the stock that is used to price the call. When I was at the bank, I had already noticed that Novartis had one of the lowest 'vol' of all the "blue chips". So if you sell a call on Novartis, you will sell it at a really not very high price, especially with the commercial margin. There you go 🙂

Maybe this argument of the commercial margin is the most convincing in fact. If the guy who sells you this product wins a lot for sure it is because there is a problem. That is why we have an account at IB and we hold shares directly, right? 🙂

There you go, sorry for not coming up with an A+B proof 🙂 I advise to stay away because I think that on average and in the long term we do not get by with these products; but that does not prevent the profile of these trades (selling a call) from being able to make us a winner for a long period, with a very high percentage of winning trades.

[dividinde]

Thank you Frouzback for your warning and your advice that I know is kind. And yet, I have always been like those overly curious children who need to put their hands on the hot plate to really learn that it burns… or maybe I am just a bit simple? 🙂

You are of course right that banks sell these products to make money in their pockets and that the prices are not to the advantage of the customers. But that is the principle of capitalism and it is not very different from what your mechanic or your dentist charges you.

I spent two weeks reading everything I could find on covered call writing. What had always dissuaded me from going further with this strategy is indeed its biggest flaw: limiting potential gains on the upside, while only very partially reducing potential losses. But this time I decided to go a little further in my reasoning and do my own calculations.

I came to the conclusion that this strategy had its advantages and deserved that I give it the benefit of the doubt. On the other hand, I completely agree with you on the fact that this strategy should not be used with all the stocks in your portfolio. For me, it is out of the question to sell calls on quality stocks that I do not want to part with and for which I see great bullish potential in the medium and long term. Why indeed risk losing diamonds such as Nestlé, Geberit or Lindt that have the pleasant tendency to at least double in value every 10 years?

There are, however, other stocks that are certainly solid, but that do nothing but move sideways for decades. Novartis is really the best example: I am happy to have it in my portfolio for its stabilizing side and its generous dividend. On the other hand, the price has gained about 30% in 20 years, which is as flat as Jane Birkin…

Why not treat this stock like a cash cow and try to "milk" a little more passive income from it, while being perfectly prepared to have to part with it and in the process a nice capital gain on the price? With a stock like Novartis, I am convinced that I will not miss out on gains of several hundred % and that, if I wish, I will always be able to buy the stock back at a more or less equivalent price.

Of course, as you write, these soporific stocks are the ones that offer the lowest premiums. But that's where I did my own calculations and came to the conclusion that it was still worth it. Basically, here's what it gives: with buy and hold, Novartis gives you about 3.8% per year thanks to its dividend. But by selling (AFTER receiving the dividend!) every 2 months an option about 5% OTM, you receive a premium of about 1.1-1.2%. Let's say 1% for simplification and to take into account brokerage fees.

Until this option is exercised, you sell a new one and receive a total of about 6% per year. With the dividend, you earned about 10% in one year (instead of 3.8%), which is frankly extraordinary for such a cushy and defensive stock.

If this option is exercised, same balance sheet: 3.8% dividend + 5% capital gain + 1% premium = approximately 10%.

In both scenarios, you earn 10% per year with one of the most defensive stocks on the entire Swiss market. You do much better than with buy and hold and the downside risk is slightly lower (thanks to the option premium) than with just holding the stock. The only real risk is indeed an opportunity risk: if Novartis goes up to the sky like a rocket, you do not benefit from the price increase beyond these 10%. This scenario is so unlikely that I prefer a guaranteed and passive gain of 10% year after year, to a hypothetical exorbitant gain on Novartis.

I think it's important to clarify that my primary goal is to generate as much passive income from my portfolio and live off of it. My primary goal is NOT to see my portfolio increase in value as much as possible.

In summary: sell covered options, yes, but only with some positions in my portfolio. Continue to profit from bull markets, yes, but with other stocks in my portfolio better suited for that.

I will do my experiments and will not fail to share my results with you over the next few months. Thanks again for your explanations and your point of view which is also defensible.

[Jerome]

Gladly for a little update in due time bro!

[Author]

Posts