Long-Term Investors and the Covered Call Strategy

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Questions from a reader:

After reading so much about selling covered calls, I am wondering about using this strategy for the long term. If I invest $20,000 in SPY, for example, and plan to hold it for the next 20-30 years, would it make sense to sell a covered call that is far out of the money in order to try and guarantee not having to sell the stock? I know the premium would be low, but would that extra premium income make a difference over the long term?

Also, would I receive dividends if I kept using this strategy where the buyer was not exercising?

Answers:

There is NO GUARANTEE that the market will not undergo a large rally, and it is always possible that the call option will be exercised by its owner.  The strategy that you describe is the sale of low-Delta options, such that the chances are very high that the option will expire worthless. But please remember that "very high probability" is never 100%.

Next, it is important to consider this strategy from the perspective of the option buyer: If an option is (almost) guaranteed to expire worthless, why would anyone pay anything to own it? Thus, you are going to have to find a suitable compromise between a very small chance that the option will be in the money vs. the premium that you can collect. Assuming that you prefer to sell short-term (expire in 2 to 5 weeks) options because they offer a much higher annualized return, then you must accept the fact that the premium will be small.

Therefore, your decision has to be made by considering these facts:

  • You own 1,000 SPY shares (roughly $20,000) and will write 10-lots every time that the previous option expires worthless.
  • If you collect $0.10 per option and pay a $10 commission, that leaves you with $90. Earning $90 in four weeks on a $20,000 investment gives you a return of 0.45%. That's pretty small, but it is 5.4% when annualized.That is a nice extra annual dividend but is far less than most people who adopt covered call writing try to earn.
    NOTE: Option premium is not a dividend, nor is it taxed as a dividend, but for the purposes of this discussion, you may think of it as an extra dividend.
    NOTE: I chose ten cents premium because it is about as low of a premium that you can reasonably consider. It does not feel right (to me) to sell options for less -- even though you want a tiny probability of exercise. Selling ten calls @ $0.05 nets only $40 after commissions.
  • If your main objective is to avoid  being assigned an exercise notice, then do not get greedy.

The answer to your main question is a qualified "yes." You can sell reasonably far out-of-the-money calls at fairly low prices. But if you plan to do this again and again for decades, then you must accept the fact that there will  be at least one occasion where you (if you want to keep the SPY shares) will be forced to cover (i.e., repurchase at a loss) those options. Over a period of 240 to 360 months, looking at the statistics tells us that it is going to happen more than once.

If you understand that one description of "Delta" is that it represents the probability that an option will be in the money at expiry, then you know that when selling a call whose Delta is 1, you can anticipate that it will be in the money at expiration approximately one time out of every 100 trades. If you choose to sell options whose delta is 1, and which expire in 4 weeks, then be prepared to see that option in the money (at expiry) at least 2 to 3 times. And if you sell 2-week options, you will write calls between 500 to 700 times over 20 to 30 years, and that means your options should be in the money (at expiry) about once every 100 expirations -- or once every two years.

Take it to the bank that the options will not always expire worthless.

Thus, the decision is simple: Is the $90 premium sufficient to make this a good strategy for you?  The truth is that I have no idea. It is YOUR comfort zone that matters, not mine. In the vast majority of cases, your plan will work as designed. If you can accept that scenario, then I see nothing wrong with adopting this strategy. But, it will be necessary to maintain discipline over the years. if you get greedier (and believe me when I tell you that it will be very tempting) as time passes, just know that collecting a larger premium will result in more frequent assignments.

Dividends: Yes, you would receive dividends, unless you are assigned an exercise notice prior to ex-dividend day. Be VERY AWARE: SPY goes ex-dividend on expiration Friday, every 3 months.

Therefore, if the option owner wants the dividend, he/she will exercise Thursday night, one day prior to the Friday expiration date. When that happens, you do not get the dividend. Thus, if your option is in the money on that Thursday, you may be assigned and lose the dividend. The call owner will only exercise when the option is far enough in the money to minimize his/her risk (that is a story for another day).

Making a difference. Yes, this makes a difference, but the difference becomes significant only when you reinvest the extra earnings. When (not if) you reinvest the ordinary dividends, be sure to add the premium collected from writing covered calls to that reinvestment. I do not know how often you will choose to reinvest the dividends, but once per year should be the minimum.

Writing covered calls is an option strategy for the investor who wants to earn additional profits. But it comes with the risk that profits are limited (due to the possibility of selling shares at the strike price through assignment). Your strategy reduces but does not eliminate that risk.

My advice: Go for it.