The House Always Wins

As I have alluded to in previous columns, I use covered calls to generate market-beating returns. A recent report from Goldman Sachs (NYSE: GS) summed up why I am such a fan of this strategy, noting: “Since 2003, every buy-write strategy we tested outperformed the total return of S&P 500 on a risk-adjusted basis, regardless of strike selection.”

If you are unfamiliar with the concept of covered calls, let me review the gist.

Options for Beginners

An option gives the right, but not the obligation, to buy or sell shares at a defined price and on or before a defined time. A person who buys a call option is buying the right to purchase 100 shares of stock. The person who sells a call is creating the obligation to potentially sell them.

Options define the price at which the trade would be executed (the strike price), the date by which the trade would occur (the expiration date), and the premium (the cost) of that option.

The share price of the stock is important since you have to have 100 share increments of any company for which you plan to use this strategy. If the share price is $4.00, an option contract represents $400 of stock.

If you own 100 shares of stock, you can sell a call against those shares (for most publicly traded companies). Or, you can use a buy-write strategy to sell the call at the same time you buy the shares, which reduces the cost of the shares. But the call obligates you to sell your shares at some point in the future if the price is above the strike price.

I favor using covered calls as a way of boosting income. I look for call premiums that are valued at least as much as a quarterly dividend. Hence, it’s similar to simply doubling up on dividends.

The caveat with covered calls is that the upside potential is capped. Once a stock rises above the strike price, you no longer benefit from the rise. You gave that up in exchange for the certainty of the premium. The person who bought the call was betting on a rise above the strike price, while you are hoping your shares don’t get called away.

Which side usually wins? Let me share my own experience.

The Nightmare Scenario

Last year I sold a covered call on a company called Medifast (NYSE: MED). To make a long story short, Medifast represents the nightmare scenario for the call seller. I usually target an annualized return of 30% if my shares get called away, which represents a 15% or so premium if I sell a call expiring in six months. That’s what I did with Medifast, but the share price actually more than doubled within six months. I lost out on a lot of upside in exchange for that call premium.

That’s a bitter pill to swallow, but you have to look at the big picture. Medifast isn’t the norm. So, let me share with you the overall impact of covered calls across my entire portfolio in 2020.

I have one brokerage account that is devoted entirely to covered call positions. At the end of 2020, that account held 22 stocks, with covered calls on 21 of them. Of the 21 with covered calls, eight (or 38%) had gone above the strike price. That’s a pretty high percentage, but it reflects a strong stock market recovery in the second half of 2020. When the market is making big upward moves, you will often cap your gains. (Note that you can reduce the chance of shares being called away by setting a higher strike, but you will receive a lower premium.)

The result of those eight calls that went above the strike price was that I missed out on $15,177 of gains. Just over half of that ($7,634) was a capped gain from my Medifast position. The buyer of the call is going to enjoy those gains, which is why people are willing to buy those calls. These are the kinds of missed opportunities that tend to stick with us, like a stock you sold at $20 only to see it rise to $200.

The Bottom Line

However, I think we bemoan those missed opportunities more than we celebrate our successes. Allow me to illustrate.

The proceeds of the 21 covered calls I had sold amounted to $23,603. So, although I hate that I missed out on $15,177 of gains, $23,603 is bigger than $15,177. So the net impact on my portfolio of selling these calls, after accounting for capped gains, was +$8,426. That added nearly 8% on an annualized basis to my returns, above and beyond the basic return of this portfolio.

The lesson here is to always focus on the big picture. Consider casino operators. Sometimes they have to pay out big jackpots. But over time, the house always wins. That’s why I am not a gambler, but it’s also why I like to sell covered calls.

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