The Reality of Selling Covered Calls for Passive Income: A Deep Dive

Are you intrigued by the idea of generating passive income through options trading? You’re not alone. The allure of using covered calls to boost your existing portfolio returns seems almost too good to pass up. “Options” and “risk-free” are seldom used in the same sentence, yet I encounter countless people using these terms to describe selling covered calls on social media.

My findings? It is not passive, nor is it risk-free. Allow me to explain.

Demystifying Options: A Beginners Overview

Skip this section if you’re already a savvy investor. For many, options trading can seem very daunting. Imagine options as tickets in a financial theater — they give you the right, but not the obligation, to buy (call option) or sell (put option) a stock at a predetermined price.

The Long and Short of Calls and Puts

Think of a call option as a “golden ticket” you can purchase that allows you to buy stocks at a bargain if the market price soars. Conversely, a put option is your safety net, letting you sell stocks at a pre-agreed price, even if the market plummets.

Short Calls and Puts: The Other Side of the Coin

When you’re selling a call option (a short call), you’re the one selling this golden ticket. Your profit? The premium they pay for this golden ticket. If the stocks plummet, the ticket holder won’t exercise their option because the stock is cheaper on the open markets, allowing you to pocket the premium. Similarly, selling a put option (a short put) means you’re ready to buy stocks if prices drop, banking on a market rebound. The ticket holder (who bought the put option) won’t sell you their shares if the stock is now worth more than the strike price.

The Beautiful Symmetry of Options

This chart is called an options payoff diagram. It elegantly captures the essence of options trading through a symphony of symmetrical payoffs. It encapsulates the concept of balance between buying and selling, puts and calls. Think of this as your compass for navigating the options market, with each quadrant representing a cardinal direction in profits and potential losses.

In the north, you have the “Short Put” and the “Short Call”, where you sell (or write) options. Here, profits are capped at the premiums received, shown as the flat lines that meet the y-axis at the height of the premium. The risk, however, diverges. As the price moves below the strike, the short put faces potential losses up to their stock position, less the premium paid. The short call’s downside grows with rising stock prices, and is essentially uncapped because they have to sell the stock at a large discount as the stock price soars.

Conversely, in the south, the “Long Put” and “Long Call” displays your rights as a buyer. The cost of entry is the premium paid, from which point profit potential grows. In the long put, profit grows as the stock price decreases below the strike price. It’s mirrored by the long call that climbs in profit as the stock increases above the strike price.

This framework serves as a mnemonic device: sellers above, buyers below, with risk and reward paths clearly delineated. Remembering this framework helps you visualize risk-reward dynamics to options — helping you navigate this financial theatre.

The Art of Selling Covered Calls: A Strategic Play

Let’s focus on covered calls. If you own a stock that you expect to remain relatively stable or only increase moderately in price, you may choose to sell a covered call as a way to earn extra income on your portfolio. This approach is particularly appealing if you’re seeking to earn extra income from the premium received from selling the call option, while still holding onto the stock for potential long-term gains or dividends. It’s an effective method to augment returns, especially in a flat or mildly bullish market, where the risk of the stock price exceeding the call’s strike price (and thus being “called away”) is minimal. This strategy bolsters portfolio profitability by leveraging stock holdings for additional income, without the need for selling them.

Owning 1,000 shares of a stock like VTI and selling a call option against it sounds straightforward. But the real game lies in the strike price — set it too high, and you play a safer, albeit less lucrative game as premiums are lower. Set it too low, and you might miss out on bigger market gains because the option might get called, and you forgo the opportunity cost of holding onto the stock as it appreciates. Let’s walk through an example below.

A Real-World Scenario: Playing the Numbers

Picture this: you’re confident that your 1,000 shares of VTI that you bought at $200 won’t exceed $220 in the next two weeks. By selling a covered call, you agree to sell your shares at a specific strike price. You sell a covered call at $0.50 per share, collecting $500 in premiums. VTI closes at $219 two weeks later. Close call! Your options expire unexercised, and you pocket $500. Annually, this could translate into an extra 7% on top of VTI’s long-run 7% returns, effectively doubling your returns!

The What-Ifs: Calculating the Risks

But what if VTI skyrockets to $230? Your shares get called away at $220, resulting in a profit of $20 per share (from $200 to $220) plus the $500 in premiums. That’s a total profit of $20.5K. However, without the covered call, your potential profit would’ve been $30K (unrealized), pointing to a “loss” of $9.5K in opportunity cost of stock price appreciation. Taxes further complicate this calculation. You might be on the hook for capital gains taxes from the sale of your VTI shares that were called away, potentially shrinking your profit.

The diagram below compares the payoffs between selling a covered call, and just holding VTI.

Summing up, with a covered call, your upside for stock price appreciation is capped at your strike price. You forgo any appreciation beyond that because you’re selling VTI to the option holder at the strike price. Plus, you’re on the hook for capital gains taxes on the sale of your shares.

Risk Mitigation Strategies

Selling covered calls isn’t just about setting and forgetting. There are strategies to employ to prevent your options from being assigned.

Buying Back the Option: An Active Approach

The primary strategy is to repurchase the option before it gets exercised. This reality shatters the myth that selling covered calls is a passive strategy. It’s a game of vigilance. You need to monitor your options to prevent unwanted exercises, which can trigger capital gains taxes on unrealized gains. If VTI’s market price is inching close to your strike price, to avert the obligation of selling your shares at the strike price, you can buy back the option. The premium will be higher than what you sold it for.

Continuing with the earlier example, VTI is now $219 and you buy back your options at $8.00 a share because you think it will exceed the $220 strike price before the expiration of the contract. This move dents your unrealized profits by $8K.

The Art of Rolling Options: A Tactical Maneuver

Another strategy lies in the art of rolling options. This can be done in two ways. Both approaches aim to defer or prevent the sale of your stock, operating under the belief that the stock price will either drop below or not exceed the strike price in the near future.

• Roll Out: Buy back the option before it’s exercised, and immediately sell another covered call at the same strike price but for a later date.
• Roll Up and Out: Here, if VTI’s price has climbed significantly, you might opt for a higher strike price for your new option.

It’s a balancing act, where you collect premiums on the new options, offsetting the costs of buying back your initial options. However, this isn’t a risk-free play.

Navigating a Bull Market: The Cost of Rolling

In a persistent bull market, the expense of continuously rolling your options can accumulate rapidly. It's like being in a financial quicksand, gradually eroding your unrealized profits. Each time you roll, it's essential to weigh the costs against the potential benefits and the opportunity cost of having your shares called away at a new, potentially higher strike price.

Case study: The Balancing Act of a NVDA Investor

Before AI became popularized with ChatGPT, a fellow Boglehead reader, let’s call him Peter, identified the latent potential in NVDA. With a decade-long horizon, Peter wasn’t just bullish; he was confident of NVDA being at the forefront of the AI revolution. He decided to implement a strategy that would allow him to profit from NVDA’s volatility while maintaining a substantial position in the stock: selling covered calls on 50% of his holdings.

Peter’s strategy aimed to generate a steady stream of income from premiums while still participating in NVDA’s growth. His plan hinged on the assumption that NCDA, while poised for growth, would not experience a meteoric surge in the short term. This strategy was not without its risks, but Peter was playing the long game. Or so he thought.

Fast forward 18 months, the landscape had shifted dramatically. The AI boom led by ChatGPT catalyzed an unprecedented bull run in NVDA. The stock didn’t just grow. It tripled in value in a manner even the most optimistic bulls hadn’t anticipated.

Peter watched as NVDA's price eclipsed his strike prices quarter after quarter. Each call he sold was exercised, and he "locked in" the stock appreciation up to the strike price. On one hand, the strategy was a success—he had secured substantial gains and the income from the premiums was nothing to scoff at. On the other hand, Peter couldn't help but reckon with the reality that he had missed out on the full extent of NVDA's meteoric rise. For every call that was exercised, he sold shares that would have been worth up to three times as much had he simply held on to them, as he did for the other half of his NVDA holdings.

This case exemplifies the double-edged sword that is the covered call strategy. Peter’s tale is one of success tinged with the bittersweet realization that sometimes, the market can defy even the most bullish expectations. His experience serves as a valuable lesson for speculative holders who might consider a similar path: while selling covered calls can provide income and some degree of protection against downturns, it can also cap potential gains, leaving investors wondering "what if" during unexpected bull markets.

Conclusion: A Strategy with Caveats

Selling covered calls is akin to picking up pennies in front of a steamroller—a strategic and potentially lucrative endeavor, but not without its adrenaline-pumping risks. It's far from the set-and-forget, risk-free income dream. This method demands a keen grasp of market tempos, vigilant monitoring, and nimble decision-making. While adept players may double their market returns, they dance with the peril of missing out on extraordinary gains—feeling shrewd in their penny-pinching, until on rare occasions, the market steamroller barrels through, leaving them to reckon with the cost of caped profits.