INVESTING
Can You Make A Living Off Covered Calls?
And why “can” doesn’t mean “should.”
Tap a couple buttons in your brokerage’s app. Collect some cash to spend as you see fit. Rinse and repeat.
It’s the peak of “internet money.”
And it got me thinking…
Might that be more realistic than it sounds?
See, I often write about covered calls because they’re an accessible yet surprisingly powerful tool for cash flow. Like a DIY dividend, if you will.
And we all know a 7-figure dividend portfolio can cover at least a basic cost of living indefinitely.
But could covered calls get us there faster? In other words, can they help us approximate retirement-level cash flow without a conventionally retirement-size portfolio? Most importantly, how precarious is this income?
After kicking some numbers around, here’s what I’ve found.
- Compared to a strictly dividend portfolio, you could live off about 1/4 as much equity with covered calls. Depending on your risk tolerance, you might get by on even less.
- This works well during neutral to upward markets, during which an 18% annual yield (including dividends) is reasonable and even conservative. (Assumption: selling .20-something-delta calls on large, stable stocks with multiple decades of dividend growth.)
- This is extremely fragile during large, extended downturns. In that event, you’re only likely to get worthwhile premium at a strike prices below your cost basis. Those are rarely prudent to sell, so premium income will dry up during such periods.
Below, we’ll take a closer look at how this might play out.
I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
Setting an income target
Let’s shoot for $36,000/year or $3000/month (pre-tax) on average. That could cover a bare-minimum cost of living for one person in parts of the US—and certainly most other parts of the world—leaving us free to take a sabbatical, travel a bit, pursue low-paid but fulfilling work, etc.
If you want to support a family or just live like a king, then multiply all the above by two or ten or whatever floats your boat.
For a totally hands-off dividend portfolio that yields around 5%, we’d need $720,000 in equity (at today’s cost) to meet this cash flow target. Many REITs and covered call ETFs handily exceed this yield even at current prices.
What are realistic returns with covered calls?
Each month, covered call premiums are typically anywhere from 0.5% to upwards of 5% of the value of the underlying shares.
But if I were to live off the returns, I’d shoot for around 1-2%/month in call premiums.
That means focusing on the same sorts of companies that belong in a dividend portfolio. After all, we’re just using covered calls to build a sort of “enhanced” dividend portfolio.
A sample covered call scenario
Let’s take Lowe’s (LOW) as an example. They’re a Dividend King, with a remarkable 59 years of consecutive dividend growth and current dividend yield of 1.53%.
In other words: very stable.
You wouldn’t actually put all your eggs in one basket, but in a handful of businesses with roughly similar risk and return profiles. LOW is just a representative example.
Right this moment, it trades at $208.82. You could collect about $140 from a 0.26-delta call ($215 strike) with 18 days to expiration. The underlying 100 shares would cost 100 * $208.82 = $20,882 if purchased today. The premium would effectively pay you just under 0.7% of the cost for those 18 days.
Two weeks later, let’s say the call has lost nearly all value and we roll it to another call with similar parameters. That makes two positions returning 0.7% each, for a total of 1.4% in a month. (Yes, premium will fluctuate, but we’re trying to keep this simple.)
We’re withdrawing cash for living expenses so there’s no compounding to account for.
If the share price basically stagnates for a year, then we’ll get about 1.53% + 12 * 1.4% = 18.3% returns over the year.
At that rate, our $36,000 income target requires about $197,000 in equity. That’s just over a quarter of the value of a hands-off dividend portfolio.
But if it sounds too good to be true…
Reality check
We can’t do that like clockwork.
The shares will occasionally be called away, drop significantly, or even both. Perhaps in the same year…
Assignment is all right
As you might know, delta is a rough estimate of the chance an option will expire in the money (meaning we’d get assigned, i.e., be forced to sell our shares). If we stick to about 0.26 delta, then we’ll be assigned about 26% of the time.
Now, our call’s strike price is $6.18 out of the money, so we’ll pocket $618 when that happens—in addition to the original $140 in premium.
We can then buy back in to LOW (possibly at a higher cost basis…) or open a different position that’s a better value. Either way, getting assigned occasionally doesn’t upset our cash flow plans. Yes, there’s an opportunity cost on any upside past our strike, but it’s still profitable.
(And that $618 in capital gains should offset the premium we don’t collect while waiting for another good opportunity.)
Drawdowns are very, very bad news
This is by far the biggest problem with trying to live off covered calls.
Unlike dividends, they’re directly linked to the share price. Sure, a crash would increase volatility and therefore premiums, but nowhere near enough to offset the decrease in share price.
Just how precarious is this?
Let’s say LOW plummets to the tune of -40%. They’ve actually raised payouts during recessions—as have all their fellow Dividend Kings—so we’ll assume dividends per share don’t change.
The lower share price means dividend yield is now 2.55%/year, plus we’re still collecting around 1.4%/month in call premiums. That means 2.55% + 12 * 1.4% = 19.35%/year, assuming the downturn lasts at least that long.
But lest we get comfortable…
Here’s where it gets ugly.
Remember from above how we could achieve $36,000/year on a covered call + dividend portfolio of just $197,000?
Well, the crash took our equity down to just $118,000. While 19.35% is a terrific return, it’s a bit shy of $23,000/year at this point.
Guess we’re going back to work.
And it gets worse. Practically speaking, most of even that reduced amount is off the table.
Again, LOW is now trading 40% lower at just $125.29, so we can’t keep selling .26-delta calls during this recession.
Why not?
Well, our same old .26-delta call would be closer to a $130 strike. Assuming we paid more than $130/share, that call would commit us to a large capital loss (or to potentially expensive rolling) if there’s an upswing.
The juice isn’t worth the squeeze.
Of course, we can avoid that predicament with strike prices up near our cost basis. Unfortunately, those are so far out of the money that they’d carry almost no premium at all.
Maybe a few bucks per week…maybe…if we’re lucky…
So, for all intents and purposes, call premium is out of the question after such a sharp decline.
We’re left with no cash flow besides dividends, which are just over $3000/year.
Not per month, per year.
So much for financial independence.
An interesting idea, but proceed with caution
During steady or upward-trending markets, covered calls reliably generate a lot of cash flow. It can feel like you’re right on the verge of financial freedom.
But sooner or later, a downturn will happen. Dividends may remain high, but call premiums will drop like a rock, along with share prices.
Worse yet, in a severe downturn, any call with worthwhile premium may be far below your cost basis. Sure, you can risk it with those lower strikes, but you’d also risk a huge loss in the event of an upswing.
My take?
If I can’t live off the cash flow following a 30%-50% drawdown, I’m not financially independent, period.
Covered calls (and any number of other strategies) can absolutely support steady, long-run growth. But rather than rushing to live off of them, it’s wiser to stay the course and reinvest premiums during the good times than to seek an enticing but precarious shortcut.
