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Executive summary:

  • $1000 per year invested annually in a Roth IRA from age 18 to 67 into an S&P 500 ETF can be expected to grow to $2,400,000 at retirement.
  • Use of covered call writing on selected dividend income equities can generate yields of 8%+, while lowering market risk & providing income security to ride out downturns.
  • The Super Tortoise Portfolio converts your $3/day savings into $192,000 annual tax-free income forever!
  • This installment, part 3, reviews option basics and examples of using covered option writing to build your Super Tortoise Portfolio.

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In part 1 of this series, Why You Should Invest Like A Tortoise, Not Like A Hare, I showed that historic data indicates a statistical certainty of achieving about 12+% annual yield rate if a person makes a single investment in the S&P 500 market basket of companies (NYSEARCA:SPY) for a period of 25 years or greater. Part 2, $3/Day Can Buy $192,000 Annual Tax-Free Income Using This Strategy, laid out the criteria and purpose of the Super Tortoise Portfolio.

This installment, part 3, provides an overview of options, covered option writing and examples of writing a covered call and a cash covered put. Readers familiar with options may skip the option review and go directly to the lower section labeled Selecting Dividend Income Equities for your portfolio.

A brief review of options and their use:

Options are a contract that provide the holder with the right to either buy (a CALL option) shares of a specified company at a specified price (the STRIKE price) from the Call Option Writer or sell shares to the writer at the Strike price (a PUT option). Further, the contract expires on a specified date (the EXPIRATION date, usually the 3rd Friday of the month). For the option, the writer is paid a fee (the Premium) at the time the option is written. Call option buyers expect prices to rise. Put option buyers expect prices to fall.

The person that creates the option contract is the Writer. They may own the shares that they commit to give the buyer of the option to purchase under the CALL contract. In this case, it is a Covered Call (covered by the shares the writer owns). If they write a Call contract without owning the shares, then it is a Naked Call and they would have to go to the open market and buy shares at any time the Call contract purchaser decides to exercise his Call contract option and buy the contracted shares at the specified Strike Price.

Naked calls are a short position in a stock and have theoretical infinite exposure. No matter how high the contract shares rise on the open market, the writer of the Call must pay that price and still be limited to selling them to the Call holder at the Strike price. Naked options are very speculative in nature and highly leveraged (each option contract is for 100 shares of the stock). Naked options are gambling, not investing.

Covered Calls, on the other hand, provide a limited exposure to the Call writer since the writer picks the Strike price and owns the shares already with a known basis value they have invested. Thus, the writer can pick a strike price that insures a specific profit from their basis value or a pre-determined loss if a Strike price below basis value is selected and the shares do get purchased by the Call holder (Called Away). Covered options are limited in gain and loss exposure and that maximum gain or loss is chosen by the writer at the outset. In this manner, a judicious selection of Strike price can insure a profit if the shares do get called away (the option holder chooses to buy at the strike price) and at the same time the writer receives a premium fee from the buyer which the writer keeps regardless of whether the option is ever exercised by the holder. The writer is in total control, they select the Strike Price, the premium fee they will be paid, and the length of the contract time, during which period the holder may choose to buy the shares by paying the Strike price to the writer.

This may all sound a bit confusing if the terminology is new to you. But let's look at an example to clarify things:

On August 20, 2013, I bought 1800 shares of Ford (NYSE:F) for $15.96/share. I immediately wrote 18 Call option contracts with a Strike price of $16 and a contract expiration date of December 20th. I sold these for $0.96. This immediately paid me $0.96 X 100 shares per contract X 18 contracts = $1,728.00 as a premium payment for the option contracts.

There are several important points about the Ford shares and Call option contract that we need to focus on:

  1. I bought Ford because I believed it to be a good value at $16.00/share based on fundamental and technical analysis. You can do your own research and analysis (I recommend it) or you can rely on the work of others for that, such as myself and other authors here at SeekingAlpha.com and other investor sites.
  2. One of the reasons I picked Ford is that it was paying a $0.10 per share quarterly dividend (2.5% annual rate) and likely to increase distributions quickly for the next few years. Happy to own the company at $16/share with a 2.5% dividend, I was prepared to hold the company long term through ups and downs.
  3. The $0.96/share option premium fee I immediately received can be looked at in a few possible ways. A) It immediately lowered my cost basis to $15.00 per share instead of $15.96. Thought of this way, I had instantly received a $0.96/15.96 return. This is a 6.02% gain on my $15.96 paid share price. B) A second way to look at it is that I effectively bought my shares at a 6.0% discount from retail market price (given my adjusted cost value) instead of paying retail prices. C) a 3rd view is that I have received $0.96 for a 4-month obligation to sell my shares at effectively the same price I paid for them originally. As such, I sold all of the near-term upside gain potential on them and retained the same market downside exposure I had without the option. The Call Option Buyer paid me 6.0% of my purchase price for locking me into this situation for the next 4 months (120 days until expiration on December 20th). The gain (6.0%) divided over 4 months was 1.5% per month. Multiply this by 12 to convert that to an annualized rate and I had earned 18.0% annualized on my $16/share investment just for continuing to hold the shares for 4 months (which I had planned to do from the outset of my purchase regardless of the situation anyway). Even if my shares did get called away from me by December 20th, I had an annualized rate of gain on them of 18.0% just from the Premium paid. This is a greater gain than I hoped to get by holding the stock itself for that period even if it performed to my expectations. So even if compelled by the contract to sell my shares for $16 and settle therefore for a net profit of $1.00/share (after allowing for the Premium received), I made a better than average market return while having cushioned against as much of as a $1 downfall in the price of the shares if the share price fell while I held it. Thus, my market risk was reduced 6.25% during the same holding period as compared to if I had not written the Covered Call. I also received $0.10/share in dividends during this 4-month holding time, further enhancing my gain by 2.5% annualized. That is a 6.0% premium + 2.5% dividend = 8.5% annualized yield rate on Ford even though it was only paying 2.5% dividend yield to shareholders who bought and held shares without writing covered options. In the event the option holder had exercised the option earlier than its expiration date, my absolute gain would have remained the same but my annualized yield would have effectively increased because of the shorter holding time.
  4. In the event the share prices did not rise significantly above $16/share and closed at $16 or less on December 20th, the option would have expired without being exercised by the holder. I would have retained my shares (as I had planned from the outset when I made the original purchase) and still kept the $0.96 premium I was paid. This is the 8.5% total annualized yield rate discussed in 3.C above.
  5. At anytime, I could close out the Call Option by buying Call options for the December 20th Ford $16.00, thus offsetting the options I had written and sold. This is called Buying To Cover, or Buying To Close. The profit or loss on the options in that case would depend on the price I had to pay to buy the Call Options to Close.

Having dissected a covered call option write, I hope the terminology, processes, and motivations are a bit clearer for you. Next, I will discuss Put Options and walk through an example from my recent portfolio positions.

Put Options are in a sense, the opposite of Call options. The buyer of the option is given the right (but not the obligation) to sell you shares that they own for the Strike price at any time during the duration of the contract. This hedges the buyer against downward share price moves by locking in the price he can sell for while at the same time allowing the buyer to continue to hold their shares if the price moves up. The Put option buyer also avoids defensive selling before an expected price decline and triggering tax of any profits they would have in liquidating their holdings at that time. This may be to push things into a new tax year or simply to hedge against a pull back with expectations to continue to hold unless the pullback is of longer duration. It should be noted that 90% + of all option contracts expire without exercise, they are simply hedge vehicles or speculations (naked) that did not go as hoped for the holder.

The rules for a Put Option are essentially the same as for a Call. The writer of a Covered Put Option is giving the holder of that option the right (but not obligation) to SELL their shares to the writer at the Strike price during the duration of the contract. Since the writer is obligating themselves to buy shares, you clearly do not cover the option with shares you already own. Instead, you use cash to cover Put options that you write, called Cash Covered Puts. To cover the obligation to purchase, you must maintain cash in your account equal to the strike price of the contract X 100 shares. For example, a $20 put would require you to maintain $20 X 100 = $2,000 in your account for each Cash Covered Put Contract that you write at that share price. This insures the Put Holder (and the clearing house) that you have sufficient funds on hand to meet your obligation to buy the shares if the Put holder decides to sell.

Now, let's look at a real example of a Cash Covered Put from my actual portfolio:

On October 28th, Ford was trading for $17.57 and my shares were called away from under the $16 covered call contracts I had sold in August. I still liked Ford and was willing to own it for $17.50 per share. Therefore, I wrote a Cash Covered Put with a $17.50 strike price and expiring on November 28th, 30 days forward. I received a Premium fee of $0.50 per share for this, 1800 shares X 0.50 = $900.00. In consideration for the Covered Put, I had to maintain $17.50 X 1800 = $31,500 in cash in my account as a contingency to pay for the shares if the Put holder decided to sell his shares to me during the contract. $900/31,500 = 2.86% for 1 month that my set aside cash earned while securing my obligation. In reality, it was 31,500 less the $900 I was paid as premium, so my own cash was $30,600. $900/30,600 = 2.94% for yield for the 1 month. Multiplied by 12 months to convert it to an annual rate (non-compounded) means my cash was earning 35.28% annualized yield just for selling someone the option to sell me shares that I was willing to buy anyway, and selling them at a price below that I would have had to pay on the open market at that time (about $17.80). Again, the Cash Covered put allowed me to earn extraordinary returns on my cash while waiting to maybe buy the shares at my willing value price (and discounted from that day's market price). Even if the stock continued to move up in price and the Put holder therefore never sold me their shares, I was earning a greater return on my cash than any reasonably expected profit from the shares themselves. Again, Cash Covered Puts allowed me to increase yield while lowering market risk. It does so in a way that lets my cash earn excellent returns while waiting for shares to be available at my price. Most investors sit with their cash on the sidelines earning almost nothing while waiting for shares to pull back to their value target. Cover Puts allow you to get paid while you wait. Unlike those on the sidelines waiting who may never get to own the shares and never make a dime from them, Covered Call writers get paid every contract period and continue to earn more cash each time they write a new Put on the same shares as one contract expires and they write a new one.

By now, you should be appreciating the value of covered option writing. You should understand how the market risk of owning shares at a price you have determined you would buy them at anyway does not change due to the option writing. If you would be an owner at $17.50 on the open market, then you are in the same (really a better) position if you become an owner at $17.50 by being presented shares of a Cash Covered Put you wrote and sold. You still have the shares at the same price (and a lower one than it was selling for the day you decided it was worth buying). You have been paid cash which provides a great yield rate on your money if the shares move up in price and you do not get to own them. That same cash further discounts your effective basis price as the shares move down in price and you are presented the shares to purchase at the Strike price. Your market risk remains the same, but the option premiums boost yield, allow you to obtain yield from shares you do not even own, and the premium adjusts your effective cost price of shares to a discount from retail market so as to soften impacts of downturns.

Market risk has not been eliminated by the use of covered options. It is important that you only use them on shares you are willing to own long term at prices at or below the strike price you pay (or a strike above your cost and with a significant profit built in for the case of Covered Calls).

There are a couple of additional observations about option features you need to be aware of and keep in mind.

  1. Options have 2 parts to the premium. The intrinsic premium is the difference in Strike price from the market price of the shares. The time premium is the money paid for the time your asset (shares or cash) is being tied up under a commitment to the contract.
  2. The intrinsic premium will vary day to day up or down with the varying market price of the shares. The intrinsic premium will move at a slower rate than the share price because exercise is only theoretical at any given moment and future share price trends may reverse.
  3. The time premium is a wasting asset and declines every day as the remaining contract time shrinks with each passing day. Therefore, the overall trend of an option is to shrink in price towards zero for its time premium.
  4. Unless the intrinsic value rises faster than the time premium wastes, the option price will decline with time. This means that in a generally flat (sideways) market, you will be able to buy to cover at a later date for a lower cost total premium than you received when you wrote the contract and sold the options.
  5. Since the markets spend about 70% of their time moving sideways, you have a statistical profitability built into each contract your write. It's like being able to assume the role of the house at a casino or your broker's margin rates. You are being paid those margin rates instead of having to pay them.

I have now given you an overview of how covered option writing helps improve your portfolio. Next, I will discuss why the strategy has a focus on quality dividend income equities as the components to consider using when building your portfolio using covered options.

Selecting Dividend Income Equities for your portfolio:

While the careful use of covered option writing can help put your portfolio on steroids, selection of the proper type of companies and quality of them is essential. The yield boosts (averaging 12% to 18% annually) generated by covered option writing can quickly be overshadowed and even reversed if the underlying companies' value declines precipitously and for the long term.

I have developed several criteria in an effort to find quality companies with reliable dividends. The specific criteria suitable for your personal portfolio(s) will depend on your goals, ability and willingness to accept short and intermediate volatility, and overall risk level you decide is appropriate.

I will start by addressing the last element, risk level. The appropriate risk level is that which is the lowest risk that still allows you to achieve your investment goal within the time horizon available. It may be tempting to boost your yield a bit by accepting a bit more risk and thus attempt to shorten the time needed to reach your goal or increase the value of your portfolio by the end of your targeted time horizon. It is imperative that you resist the temptation. Taking on any more risk beyond the bare necessity to reach your goal is gambling instead of investing. Do not gamble with your investment dollars.

As you shorten the time horizon for your portfolio to grow, you also increase the volatility of results in terms of the size of swings in value as well as the frequency of the magnitude of those swings. In addition, in order to incorporate covered call writing into your strategy, you will generally have to select individual equities. Options are not available on most ETFs. SPY is one of the exceptions that does allow you to trade options on the ETF ticker itself. However, I personally believe that SPY, which mimics the performance of the entire S&P 500, is too broad a bundle of companies to reasonably establish value at any given time. Most SPY options traders that I know use technical chart analysis to plan their option positions and trade speculative options rather than writing covered Puts and Calls. Therefore, I have not used SPY and its options in my portfolios.

I have targeted dividend paying stocks so that they provide a stream of cash regardless of what the individual share price is doing. This is important for a variety of reasons; it provides income to those using the portfolio to live off of, the cash stream allows for re-investment and compounding over time or alternatively for diversifying and shifting balance as long-term changes in the quality and performance of your various component holdings evolve. Further, the dividend yield provides a safety net (in both absolute yield and comfort level) while weathering downturns in overall market or cyclic company performance patterns. Think of the dividends as providing a buffer to soften the bumps in the road along the investment path.

The ideal candidates for Tortoises are large cap dividend aristocrats with strong records of paying consistent dividends with growing distributions over time. The 4% minimum dividend yield I screened for excludes most of these pure dividend aristocrats. Those aristocrats tend to have somewhat lower yields, 1.5% to 3%, because they are favored by investors and their prices therefore keep rising and thereby suppressing their effective dividend yield. My initial screen will focus more on yield and less on share price appreciation. Later articles in the series may look at a portfolio of the aristocrats.

I have used a simple screen to preliminarily identify 85 companies for further study as possible portfolio candidates. The initial screen criteria includes equities with a market cap of $10 billion or greater, a P/E ratio between 1 and 35 (to eliminate extreme bubble situations and blue sky companies), providing a dividend yield of 4% to 12% (avoiding many of the mREITs and value traps with over attractive dividends hiding lurking problems), and with price performance history for the past 52 weeks between 200% rise and -50% decline (again removing the largest bubbles and those in a complete death spiral). Statistically, the filter when applied using Google's Stock Screener selects a sample from the total U.S. markets as shown in the graph set below.

(click to enlarge) (source: google.com)

The result is a far cry from the entire S&P 500 but still a very broad sample of the market components while focusing only on the Large Cap market segment. These tend to be the plodders rather than the hotrods, just what we want for our Tortoises. From the 85 tickers identified by the initial screen, I filtered out companies I found had overly unstable history of dividends, steep declining price trends, or other characteristics suggesting they did not represent value. I also culled REITs, MLPs, and some companies that represented an over redundant supply of similar companies in the same sector, such as energy or finance. The list pared down to 16 companies meeting the filter criteria and providing current option opportunities at interesting prices.

In part 4, I will discuss three (3) specific real ticker examples as they are currently priced. These will be identified and dissected in detail, step by step. Each subsequent part of the series will identify and evaluate an additional 3 current market candidates for building your Tortoise on Steroids portfolio.

I hope you will join me as I detail the use of covered option writing on quality dividend income equities to develop a model portfolio for the Super Tortoise. Simply click on the bold link labeled FOLLOW above the title at the top of this article to get an email notice of my new articles when they are published.

Disclaimer: I am not a licensed securities dealer or advisor. The views here are solely my own and should not be considered or used for investment advice. As always, individuals should determine the suitability for their own situation and perform their own due diligence before making any investment.

Source: Tortoise Strategy - Part 3: Building Your $192,000 Tax-Free Annual Income Portfolio

Additional disclosure: I also have time and price laddered positions short in Ford covered calls