I’ve posted that several times, look it up.
Usually the logical choice. 
Trades are seldom if ever mispriced. What separates best from worst is volatility. The higher the implied volatility the more time value the option has. Options 101!
Take a deep breath and relax.
Call option sellers lose less that investors who don’t sell coved calls.
An opportunity loss, not a real loss.
The Captain
Then why are you doing this? If you want the cash in your hand, just sell that amount of stock. If you own $10K of XYZ co. and want to have 2% of it in the form of cash, you can just sell 2% of your shares.
The option trade is worse for you, when you take into account all of the possible outcomes. If the stock melts down, you own the loss in either scenario - but if you’ve sold, rather than issued a covered call, you lose slightly less money. If the stock melts up, you’re vastly better off in the scenario without the covered call, for obvious reasons: you get all that upside. If the stock stays close to the strike price, you are better off with the CC of course. But the premium is based on the volatility - if you’re getting any kind of decent premium, you’re in a scenario where that’s far less likely to happen.
Options markets are efficient and premiums are fairly priced. Which means your premium is going to accurately reflect the relative chances of these things happen, and you’re not going to get any outperformance compared to simply selling the equivalent amount of your stock. But you do have to experience higher transaction costs and marginally worse tax treatment.
But…that’s foolish (small “f”). You see that, right? You are selling your LTBH port down. You’re selling away part of the future growth in that “continuing to grow” part. You’re reducing the growth rate of your LTBH port, because most of the growth in equities comes from a small group of stocks having short sharp gains - and you’re selling all that to another party. You end up with an LTBH port that underperforms relative to if you just sold off pieces of it. You get to keep the assets only if they don’t grow all that much. If they grow like a normal LTBH port, you do have to sell some of them.
Very much a real cost. If you sell someone your upside, your position in the equity is worth less. If you own a share of a volatile company at $100, the present value of the company is the sum of all of its possible future outcomes. It might go up to $120, it might go down to $80 (it’s volatile!). If you tell a third party that if the stock goes up you’ll give them the upside, then your holding today is worth less than an unrestricted holding.
It’s easiest to see if you imagine a fair lottery ticket. I sell fair lottery tickets for $10 each. They have a 50% chance of being worthless, a 40% chance of paying out $10, a 9% chance of paying out $50, and a 1% chance of paying out $150. I sell these for ten dollars (the fair EV). You buy ten tickets. Then someone comes to you and says, “I’ve got a deal for you! I’ll give you eight dollars- and you get to keep your lottery tickets! All you have to do is promise that you’ll give me your winnings over $50 if you win that jackpot.”
And you think to yourself, “hey, this is great! I get cash in hand, I still get to keep my lottery tickets, my lottery tickets will still pay me out every time it would have before, and all I’m doing is giving up some of my upside in the most unlikely event!” The problem, though, is that you’re still paying $10 for lottery tickets that now only have an EV of $9 each (because you’ve sold off the tail end high payoff). The sale of the tail end high payoff has an opportunity cost of $1 per lottery ticket, because that was a big part of the present value of the ticket. Since you only sold it for $0.80 cents, you’re actually losing money now on these fair lottery tickets. Even though you got cash in hand upfront, and gave up nothing but upside - nothing but an opportunity loss, not a “real” loss - you now have put yourself in a far worse position.
If I straight up sell shares, I lose all the future upside those shares might have had.
If I spend those proceeds to pay some bill… My overall wealth is less.
If I keep doing this … I’ll eventually run out of wealth.
That’s the whole argument behind the 4% SWR.
Selling options REQUIRES the seller to accept that she will (potentially) give up the future upside of a stock.
I’ve experience with missing out on that upside.
It DOES happen.
I accept that “risk”… Cause my strategy brought in some income, while preserving my original “stake” (the “tools” that earned that income for me).
If I straight up sell shares, I miss out on their future upside.
I’ve experience with missing out on that upside.
I accept that, too.
Lamenting those putative losses is “seller’s remorse”?
I don’t spend much time doing that.
Selling options is not for everyone.
It fits me, though.
Buying actual shares of stock is not for everyone. Some folks don’t feel safe in anything but CDs, or bonds, or dividends, or rental property.
Last year “baby got new shoes”, I paid taxes based on that income, AND I still have a fully intact LTBH port.
ralph
Is paying taxes real world alpha?
Right. But only on those shares. Which are a small fraction of the amount of shares you would have to sell away the upside on to earn the same amount using options.
Instead of my hypothetical fake lottery ticket, let’s look at a portfolio. Assume you have $100,000 in stock in a LTBH portfolio. To make the math easier, assume an average return on the portfolio of 10%. You decide you need $2K in cash. You can choose either to sell 2% of your portfolio or issue covered calls on the portfolio.
What happens in each scenario? If you sell, you now only have $98K worth of stocks to appreciate. So you have $2K in cash, and only $107,800 in the portfolio at the end of the year. In the covered call scenario, you have the $2K cash and haven’t sold any stock initially. However, we know that selling covered calls reduces the expected return of the underlying portfolio. You’ve sold away some of your upside. Over time, the effect of being called off will lower your growth rate in the portfolio. If you’ve reduced that 10% rate of return down to 7% for the covered call scenario, the payoff table now looks like this:
| Sell | Covered Call | |
|---|---|---|
| $ 98,000.00 | $ 100,000.00 | |
| $ 107,800.00 | $ 107,000.00 |
Notice how you’re worse off having sold the covered call than if you had simply sold the stock? You end up earning more on the slightly smaller holdings than on the larger portfolio, because you sold off some of your future earnings to get that premium. Sure, all you did was give up some upside - you didn’t actually sell shares when opening the position. It’s just “opportunity cost,” right? But because you gave up upside on a much larger amount of stock than if you had just sold the stock, you end up worse off. You have more wealth if you just sell the stock rather than writing the covered call.
This is just illustrative, demonstrating how you can end up worse off with the covered call than with just a stock sale. Any given scenario will vary: the stocks’ volatility will affect the amount of your premium, how much of your portfolio needs to be encumbered versus sold to earn the funds you are targeting, how much selling the option will reduce the rate of return on your portfolio, etc.
But again, we return to the core issue: in an efficient options market, the options will be fairly priced. You can’t get outperformance. Which means that the expected loss of return/risk of being called that you have to take on will end up corresponding to the amount of premium you are getting.
That means that on the whole, you’re going to be better off just selling than writing the option. The substance is likely to balance out over time, but writing the option has greater transaction costs and worse tax consequences.
No. Real world alpha in this context would be having the ability to spot mispricings in the options market (situations where IV does not accurately reflect the true volatility in the security).
I believe, that would be me!
Statistically 80% of BOUGHT options expire worthless.
That means that 80% of SOLD options don’t get exercised. The seller pockets the premium and keeps her shares.
80% of the trades result in my capital being returned to me, 100%.
(+ a little bit, cause I sold a slightly OTM strike.)
In my case, this is “preservation of capital”.
Oh. And… I got some disposable income.
I’m not selling options on my core LTBH portfolio.
The LTBH positions are “safe”.
That “wealth accumulation” continues.
----. —
“Outperform the market” is NOT the goal of SELLING options.
Investors who SELL options are earning INCOME.
An investor who wants to outperform the market should chose a strategy other than SELLING options.
SELLING options ain’t gonna* outperform the market.
SELLING options will not* outperform the market. That’s not the goal of SELLING options.
“Outperform the market” is NOT the goal of SELLING options.
Investors who SELL options are earning INCOME.
An investor who wants to outperform the market should chose a strategy other than SELLING options.
SELLING options ain’t gonna* outperform the market.
SELLING options will not* outperform the market. That’s not the goal of SELLING options.
“Outperform the market” is NOT the goal of SELLING options.
Investors who SELL options are earning INCOME.
An investor who wants to outperform the market should chose a strategy other than SELLING options.
SELLING options ain’t gonna* outperform the market.
SELLING options will not* outperform the market. That’s not the goal of SELLING options.
ralph
(* Unlikely to Outperform the market - is a better description.)
Edit to add:
“Outperform the market” is NOT the goal of SELLING options.
Investors who SELL options are earning INCOME.
An investor who wants to outperform the market should chose a strategy other than SELLING options.
SELLING options ain’t gonna* outperform the market.
SELLING options will not* outperform the market. That’s not the goal of SELLING options.
I understand, rainphakir. I know how options work - there’s no need to repeat this several times.
The point, though, is that even if your goal is to earn income, this is a foolish way to go about doing it. You’re not working a job, after all: regardless of the fact that you’re labeling it as “income,” what you’re doing is deploying cash in an investment to earn a return. You plan on spending that return in the short run, so you call it “income.” But you’re still better off doing that in a way that will yield you as high a return as possible while still accommodating your short term spending. If you invest your money in equities, your appreciation on those equities is “income” in the same way as your premiums - it’s just not in cash. You can always sell some of the asset to change it into that cash.
Buy-write covered calls end up just exposing you to all the downside risk of investing in equities with a lower rate of return. It doesn’t give you any advantage, and you end up with worse transaction costs and worse tax treatment. You’re better off taking whatever you would have put into the buy-write, taking some portion of it (say, 10%) into a high-yield savings account, putting the rest into an index fund, and just pulling whatever money you would have pulled from your buy-write strategy instead from the savings account as your “income” - then topping off the savings account with your “winnings” from the index fund. You get the same effect, with cash coming in that you can spend, with better returns. Because even though your money is mostly long equities, you’re not trading away the upside for cash while still running all the downside risk.
I don’t want to try to convince anyone to change their investing strategy, but if someone is reading along and considering doing something like this, there are a couple things to keep in mind.
If your goal is to preserve shares, keep in mind that the shares can be called away. That means you need to be willing to see your share count decrease. Since you are willing to see your share count decrease, why not employ a version of what Warren Buffett called the “homemade dividend”?
If you believe a company can successfully return 10-12%/year in profits, simply invest in the stock, and sell a certain dollar amount each year, adjusted for inflation. You’ll get the market return (which you are guaranteed not to get with covered calls), yet still generate “income”
Writing covered calls, implies a certain skill in stock selection. So I had Gemini try this strategy with a specific stock, AAPL, over the last 10 years. Before you say “Hindsight!” Ten years ago AAPL was as close to a no-brainer as you get. The company was making money faster than it could spend it, the PE was low, the PEG was low, very obvious a good stock to own.
Note the the decrease in share count was pretty modest, only about 11%, but the underlying portfolio increased by 1,200%, a CAGR of 25%. This doesn’t include dividends, but those are pretty minor.
For those of us know don’t have much skill in selecting stocks, I also had Gemini do the same thing for the S&P 500. Not as good as AAPL, but portfolio was still up 165% not including dividends, which were pretty good.
If you want income, the homemade dividend works pretty well, and requires essentially zero time, effort, or skill.
| Year | Portfolio Value (Start) | Targeted Payout | AAPL Share Price | Shares Sold | Ending Share Count | Portfolio Value (End) |
|---|---|---|---|---|---|---|
| 2016 | $1,000,000 | $40,000 | ~$25 | 1,600 | 38,400 | ~$960,000 |
| 2018 | ~$1,420,000 | $42,436 | ~$46 | 922 | 37,211 | ~$1,710,000 |
| 2020 | ~$3,080,000 | $45,020 | ~$95 | 474 | 36,541 | ~$3,470,000 |
| 2022 | ~$6,100,000 | $47,762 | ~$165 | 289 | 36,081 | ~$5,950,000 |
| 2024 | ~$7,100,000 | $50,671 | ~$220 | 230 | 35,688 | ~$7,850,000 |
| 2026 | ~$11,800,000 | $53,757 | ~$333 | 161 | 35,420 | ~$11,790,000 |
It’s got some other advantages.
It will have materially lower transaction costs. Commissions, to be sure - but the much larger bid-ask spreads in options contracts are a major transaction cost that you just don’t have to endure with simple equity trades.
And if you’re in a taxable portfolio, the tax treatment can be significantly better. Premiums are most likely going to be treated as short-term capital gains, but the homemade dividend on an appreciated portfolio can give you “income” at a long-term capital gains rate.
Yes!
Agree, if the goal is to preserve shares selling calls is not a good trade.
If you want to sell covered calls, using good value stocks is the wrong way to go. High option premiums are generated by volatility, not by valuation.
Was the covered call yield reported by Gemini a CAGR of 25%?
A 1,200% increase over ten years is a CAGR of 29.24% These are the APPL buy and hold ten years numbers price adjusted for dividends.
GoogleAI:
Yes, your math is correct: a 1,200% increase over 10 years yields a Compound Annual Growth Rate (CAGR) of exactly 29.24%.
Googie, it was my spreadsheet that did the math, Dummy! 
The Captain
Yeeeesss. Yes, I am!
I AM getting a return on my capital, and I’m calling it income.
IRS puts options premiums in the “income” section of my tax return.
Ergo, IRS also calls it income.
Absolutely!
The investor must accept the consequences of their choices.
If the investor stresses over it… then don’t do it!
In my experience, 90+% of the time that the shares get called away… Is cause I CHOOSE that outcome.
And I always accept the consequences. It’s part of the plan.
SELLING options is not for everyone.
It fits me and my goals.
I don’t much consider myself a stock picker.
I consider myself to be a person who knows how to choose people to listen to … Who, IMO, ARE stock pickers.
That skill has worked for me.
I DO think I’m skilled at managing an options trade.
That’s why when shares are called away… It’s cause I CHOOSE to allow them to be called away.
There are always shoulda woulda coulda (buyer’s/seller’s remorse) situations - for EVERY investment strategy.
When I start bemoaning a trade, I return to my original goal for that trade… The plan.
That usually stops any bemoaning.
That would require me to sell assets out of my LTBH portfolio.
I’ve already covered this.
At this point in my investing life… I don’t want to do that.
Later, I’ll perhaps move that direction.
I enjoy selling options.
I sell options in order to pay for FRIVOLOUS things.
Odyssey movie tickets. Great movie IMO.
&Juliet theater tickets. Great play IMO.
Stuff. Some stuff is great. Some gets shunted to the thrift store.
And I’m grateful to the Universe that I’m capable of investing in general and, in particular, selling options.
ralph
I’ve seen this idea from time to time.
That so many options expire out of the money (worthless), does not imply that the buyer of that option did not make money.
The buyer of an option that expires OTM can absolutely make money in a steady and repeatable way.
This is exactly how options market makers (dealers) can make money.
As has been stated many, many times, valuation/pricing of many, many options (like listed equity options) does not depend on the directional (up vs down) movement of the underlying stock.
The primary market inputs are the stock’s volatility and an interest rate.
In particular, the volatility of the stock has value regardless of the final price of the stock, be it up or down.
This is a difficult concept to understand well.
It’s an advanced, technical topic that resulted in a Nobel prize in economics.
Excellent comment!
The buyer is not buying the option if he just loses $ every time.
The buyer and seller are not working the same strategy or trade.
The buyer has his, the seller has his.
Selling Options is not an “I, the SELLER, win, the buyer loses”.
I keep saying “SELLING” … cause that’s my POV. And I’m SELLING CCs. I have MY plan, based on my goal for this trade.
My strategy shifts the potential to “win” in my favor … For my strategy.
Somebody has to BUY the option.
The buyer uses a strategy that shifts the potential for his strategy to “win”, in his favor. HIS STRATEGY.
The buyer, his plan/goals and strategy are completely opaque to me.
I’m concerned with my plan n strategy.
I don’t care what the buyer’s plan/goals/strategy is.
The buyer is NOT buying a CC. He’s buying a strike and expiry that fits his plan and goals.
His plan might be some complex strategy (butterfly, condor, spread , etc) or he’s buying a “batch”.
IDK, and I don’t care.
(The buyer does not know, nor care, the seller’s plan/goal/strategy either.)
Why is it important to recognize that I’m the SELLER?
Cause the options information is presented from the BUYER POV.
I constantly remind myself that SELLER is my POV.
ralph
I read many times that options trades are zero sum and posted many times on why they are not, in general, zero sum.
Market makers can and do make money regardless of the other side of the trade.
It’s a big, sustainable (and growing) business.
The premium part of the options trade is a zero sum game, a negative sum game if you factor in the commissions, fees, and taxes. The share part, which is what the buyer counts onto make a profit, I don’t know. So I asked Googie.
The premium part of the options trade is a zero sum game, a negative sum game if you factor in the commissions, fees, and taxes. The share part, which is what the buyer counts onto make a profit, I don’t know.
GoogleAI:
The share part of an options contract is not a zero-sum game because it is tied directly to the underlying equity market, which is wealth-creating. [1]
When an options buyer exercises a call option to acquire shares, or a put option to sell shares, they enter the realm of stock ownership. The stock market is a positive-sum game over the long term because corporations generate real economic value, grow earnings, pay dividends, and reinvest capital. [1, 2, 3, 4]
Here is how the dynamics differ between the premium and the share components:
- Premium Component: A pure negative-sum game (after friction). The option premium paid by the buyer is exactly the premium received by the seller, minus transaction costs. One side’s premium profit is the other’s exact loss. [1, 2, 3, 4]
- Share Component: A positive-sum game. If a buyer exercises a call option and holds the shares, both the option seller (who may have bought the shares years ago at a much lower price) and the option buyer can walk away with substantial positive returns. The profit of the buyer does not require a structural loss from the seller, as corporate growth expands the overall pool of wealth. [1, 2]
This last sentence is what we Fools are disagreeing on:
o o o o o o o o o o o o o o o o o o o o o o o o o o o o
As I see the covered call strategy the seller makes a premium profit and has to guard against a real share loss. Opportunity loss is immaterial in the sense that it is expected if the call is assigned. The way to protect against a real share loss is to set the strike price high enough.
The Captain
I don’t think so - I think that’s just an artifact of the way the search was framed. The AI is considering the possibility that the option writer might already have a big unrealized gain in the shares. In that scenario, both buyer and seller can walk away having realized a gain - but the gain existed before the option contract was entered into. That scenario wouldn’t apply to a buy-write situation, which is what I believe you’re engaged in.
How does setting the strike price high enough protect you from real share loss? The thing you have to “guard against” is a decline in the value of the shares that you acquired as a long position in order to cover the call.
Institutional firms avoid that risk altogether by using dynamic hedging - they constantly vary the number of shares they own to respond to changes in the delta so that they always remain delta-neutral, and thus never carry any directional risk. A covered call doesn’t do that - it reduces the tail risk from a naked call somewhat, but you’re still taking on directional risk.
The “opportunity loss” isn’t immaterial. It’s part of the expected value of a security when you open a long position without writing an option. The economic value of the security includes both a possible appreciation in the stock price if things go well and a possible loss of value if things go poorly. If you sell away the potential to obtain gains, the bundle of possible outcomes that are left to you are reduced in value: you have all of the downside possibilities, but a capped upside. It matters that you have sold away the upside, because it now means that the expected value of all of the positive outcomes is now less than the expected value of all the negative outcomes.
It is not immaterial. The hope is that the amount of the premium is bigger than the loss of value due to losing the potential upside you label as “opportunity loss,” but it is not immaterial.