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This week, we (SA) interview Mike Scanlin (MS) of Born To Sell - whose Investing Tool, Covered Call Tools, provides income-oriented investors with a best-of-breed covered call screener and portfolio management tools to maximize their monthly income.
And now, the interview:
SA: Let’s start with an overview – admittedly for an options novice such as me: What exactly are covered calls, and should they be part of every investor’s toolbox?
MS: Covered calls are an income-oriented investment strategy used by investors to generate recurring monthly income. But before we talk about covered calls, we need to understand call options. A call option is a security that gives the buyer the right (but not the obligation) to buy 100 shares of stock at a certain price (called 'strike price') on or before a certain date (called 'expiration date').
Example: If you buy 1 call option on XYZ stock with a March expiration and a strike of 50, then you have purchased the right to exercise it and buy 100 shares of XYZ stock at $50/share any time between now and the 3rd Friday in March (monthly options always expire on the Saturday after the 3rd Friday of the month).
The buyer of this call option is making a bullish bet that XYZ will be over $50/share by the 3rd Friday in March. If XYZ is below 50, then the option will expire worthless and the call buyer will forfeit the premium he paid for the option. If XYZ is over 50 (no mater how much over), then the call buyer can buy 100 shares at $50/share.
The seller of this call option is collecting premium today in exchange for taking on the responsibility that he may be forced to deliver 100 shares at $50/share at any time on or before option expiration day.
A covered call is a two part investment: (1) you are long stock, and (2) you are short a call option on that stock. The call option is called 'covered' in this case because if the call buyer exercises his right to buy the stock, then you already own the stock necessary to fulfill your obligation.
SA: Are they primarily a trader’s tool, an investor’s tool, or both?
MS: Covered calls are the single most popular options-based investment strategy. Charles Schwab has said that among their accounts approved for options trading, 84% trade covered calls. Covered calls are a great way to get 12 extra dividends per year from your portfolio of stocks and ETFs. But they’re not day-trading instruments or get-rich-quick instruments - so they are used mostly by investors, not traders.
SA: We all know that more than 75% of all options held until expiration will expire worthless, which makes the appeal of a tool that helps investors sell options - as opposed to buying them - obvious. Still, there’s no free lunch. What are the worst-case scenario risks of a covered-call seller?
MS: The worst-case scenario is that the stock portion of a covered call investment drops significantly. You will have a loss, although the loss will be less than if you had just held the stock outright in buy-and-hold fashion. The call premium you received will insulate you from the first part of any drop. But if the drop is more than the premium received, then you will have a loss.
Example: You buy 100 shares of stock at $46/share and then sell a 50 strike call option for $3 (meaning you receive $300 for the call since options normally control 100 shares). Your break-even point is $43 (the 46 you paid minus the 3 you received for the call). The best you can do on the upside case is receive $50/share (the strike price) plus the $3/share you got by selling the call. This is your profit and loss on the expiration date at various stock prices:
[Click all images to enlarge]
The P&L line crosses into loss territory at any stock price less than 43. But at any price over 43 you have made money. Remember, this was a $46 stock when we started. So if it drops by less than $3 before the option expires, you make money. Let’s compare the same scenario with a buy-and-hold investor:
The orange line is the buy-and-hold investor’s profit and loss. At values above 46 he makes money, and at values below 46 he loses money. Notice that the covered call investor (black line) does better than the buy-and-hold investor in every case where the stock price is less than 53 (and, again, this stock was at 46 when we started). So, unless the stock rises by more than 15% before the option expires, the covered call investor comes out ahead of the buy-and-hold investor.
SA: Why should an income-focused investor consider selling covered calls rather than, say, building a portfolio of safe-haven dividend stocks?
MS: There’s no reason to pick one or the other. In fact, many people do both. You can write calls against your dividend-paying stocks, too. That way you get the call premium plus the dividends. If you have a portfolio of blue-chip dividend payers you’re probably averaging 3-4%/year in dividends. Using covered calls you can double that yield (so another 3-4% from call premium per year) and still leave yourself some room for upside appreciation.
SA: What do I need to get started with writing covered calls?
MS: There are 3 things you must have and one thing that is highly recommended.
- A brokerage account to trade stocks.
- Permission to write covered calls. Many broker accounts allow this by default, including IRA accounts, but if not then you just fill out a form that your broker has in order to get permission to do covered calls.
- 100 or more shares of stock, or enough cash to buy 100 shares. Ideally, for diversification, you will have enough stock or cash so that you can own 100 shares of several different companies.
- [recommended] Covered call screening and portfolio management software. This will help you wade through the tens of thousands of possible covered calls to find ones that meet your needs, as well as help you maximize the time premium (income) you capture each month.
SA: I understand that you discourage naked call writing - because if I don’t own the stock, my risk in selling a call option is potentially unlimited. But why can’t I use the same tool to sell puts – which offer the buyer protection against a significant drop in the value of his stock?
MS: Selling naked puts is pretty much the same as writing covered calls. There can be differences in tax treatment (if the underlying stock pays a dividend before expiration), wash sale rules, margin requirements of your broker, and permissions needed at your broker. But basically, they’re the same trade.
We chose to keep Born To Sell focused on just covered calls in order to keep the user interface and strategy as simple as possible. Throughout the site you will notice a lack of complexity. We asked ourselves: If Apple (AAPL) were to design a covered call tool, what would it look like? We don’t use option geek terms (‘delta’, ‘implied volatility’, etc.) and we don’t confuse users with a dozen different option strategies. Our goal is to make covered calls simple enough that anyone can do it to generate monthly income from stocks they own.
Having said that, if you really want to write naked puts then you can use our tool to find juicy call premiums, and then use your broker to sell naked puts (usually if the calls are juicy for a given stock then the puts will exhibit similar returns).
SA: Please explain the tradeoffs between buy-and-hold investing vs. covered call writing.
MS: Buy-and-hold has unlimited upside and unlimited downside. Covered call writing gives you some downside protection in exchange for putting a cap on your upside.
If you’re worried about capping your gains then you can (1) only sell calls on a portion of your position, or (2) sell short-term options that have a high strike price. You may not get a ton of premium for them, but it’s more than zero and if you’re going to hold the stocks anyway then why not?
Covered calls may not be the optimal strategy during a raging bull market. But in any other kind of market (weak bull, sideways, or down) they will outperform buy-and-hold. Much like dividends, over the long haul the call premiums will add up and make a difference.
SA: Are there tax implications of covered calls?
MS: There are a couple of things to think about regarding taxes if you are trading covered calls in a taxable account (in a non-taxable account, like an IRA, none of this applies):
One thing to consider is that if you write a call on a stock where you have a large unrealized gain, you may not want it called away because it could trigger an unplanned taxable gain. However, if the stock rises above the strike price before expiration then you have a choice to buy back the option (potentially at a loss) to avoid exercise (and avoid the taxable gain).
There are some other tax issues regarding selling deep in the money calls. Basically, if you remove substantially all the risk of a position, then the IRS may consider it a “constructive sale” at the time you sold the deep in the money call. Your broker should figure this out for you when they report wash sales and such at the end of the year. If you want to read about it then check out IRS Publication 550.
SA: Can I write covered calls on ETFs as well? What are the advantages and disadvantages of ETFs over stocks?
MS: Absolutely. Covered calls on ETFs are common, and an especially good idea for smaller accounts because of the diversification that most ETFs provide. You can avoid single-stock risk by buying an ETF, and therefore reduce volatility caused by things like an earnings release for one of the stocks that makes up the ETF. Also, for international stocks where consistent, reliable information can be difficult to obtain, an ETF offers a way to invest in the category without having to track down specific company information.
Likewise, if you want to earn monthly dividends from gold (something that doesn’t normally pay cash dividends) then buying the ETF GLD and writing calls against it will allow you to do this.
SA: What is the difference between out-of-the-money calls and in-the-money calls? Under what circumstances would I want to use each of them? How about deep-in-the-money calls?
MS: The “moneyness” of an option refers to the relationship of the strike price and the underlying stock price. If the strike price is higher than the stock price, then the call option is “out of the money.” If the strike price is lower than the stock price, then the call option is “in the money”, and if the strike is really low relative to the stock price, then the option is “deep in the money” (usually the strike is 10% or more below the stock price to be considered “deep in the money”, although the IRS has their own definition).
If you are bullish on a stock, then you want to leave yourself some upside potential and sell out of the money call options. If you are neutral on the stock, (you think it will be the same price at option expiration as it is today) then you would sell an “at the money” call option where the strike is the same (or very near) the stock price. And, if you are bearish, or if you just want to collect time premium, then you would sell in the money or deep-in-the-money call options.
SA: As a complete covered call novice, walk me through my first possible trade using the Covered Call Tool’s search page.
MS: Sure. First you would set your time horizon (Expiration) and bullishness or bearishness (Moneyness) on the sliders:
The Expiration slider is the option expiration month you’re interested in. In this example we’ve set it to March, meaning you want to see options that expire March 19 (Saturday after the 3rd Friday in March).
Using the Moneyness filter you select your bullishness (on the right side, out-of-the-money) or bearishness (on the left side, in-the-money). In this example we’ve chosen bearish covered calls that are at least 5% in the money (ITM).
The results come up instantly and look like this:
Each row is a possible covered call trade. If you hover the mouse over the stock symbol it will give you the company name.
Row 2, for example, is saying that if you buy Rare Element Resources (REE) at 14.67 and then sell a 14 strike call for 1.70 then your break-even (net debit) will be 12.97. If REE finishes above 12.97 by Mar 19 then you will have a profit. There is 12% downside protection, meaning the stock could drop by 12% and you’d break even.
There are no scheduled earnings releases or dividend payments before the Mar options expire. If the stock finishes above 14 on Mar 19 then it will be called away and you will make 7.9% in 39 days. If you annualize that rate of return, then it’s 73.9%.
The search results also alert you to certain events, like earnings releases before expiration. Notice row 3 the Feb 16 is in red. That is the date that Dean Foods (DF) is scheduled to release earnings. If you sell the March options you will be subject to that earnings release volatility. Likewise, the search results show you any ex-dividend dates that may occur before expiration, and the return calculations include that dividend payment.
You can sort the results by any column. You can show/hide additional columns. We also have additional filters so you can do things like remove all covered calls with earnings before expiration, limit results to just S&P 500 stocks, limit results to just ETFs, etc.
SA: Your Top 10 covered call list lets me see what other Covered Call Tool users are doing. Ten is not a big variety - why not expand it to 100, or allow it to be searchable by Sector, Market Cap, Price, etc.? In general, is it wise to be swayed by what others are doing - do clients find “follow the crowd” works for or against their goal of generating income?
MS: Well, crowd sourcing has its pros and cons. The biggest pro is that it gives beginners confidence to see what other (presumably more experienced) covered call investors are investing in. We only show the top 10 because we wanted to show results owned by lots of people, not just a tiny subset of people. If you are looking for your first covered call trade, the Top 10 list is probably a good place to look for candidates.
However, we’d also recommend that for your first trade you stay away from anything with earnings before expiration, or any symbols you see listed in red (red symbols on our site are leveraged ETFs and are not for beginners).
Sometimes the crowd is right, and sometimes they’re not. It’s meant to be an idea generator, and not necessarily a set of trade recommendations. Historically, though, the vast majority of Top 10 covered calls are winners. We also have the Top 20 Watchlist feature, which shows you the 20 most common symbols appearing on our customers’ Watchlists. Another good idea generator.
SA: Combining options-writing income with regular dividends seems to be a winning combination. Can the Covered Call Tool help me to drill down to find high-yielding dividend stocks with strong option-writing potential? In your experience, does the combination of dividend-yield and options income work in real life? Is there a way to play anticipated dividend increases?
MS: Yes, we can help you find covered call candidates where you will get a dividend before option expiration, in addition to the option premium. One of our specialized search modes is called “Dividends”. At the top of that page you will see a slider where you set the minimum dividend payment you want to receive (in cents per share):
Then the results page shows only covered calls that will pay that much of a dividend (or more) before expiration, like this:
Notice the dates in green. Those are the ex-dividend dates. If you own the stock by the market close on the day prior to the ex-dividend date then you will receive the dividend listed in the Next Div Amount column. Also note that some of these have dates in red; those are earnings release dates and you may want to avoid those.
SA: Once I’ve taken a position, monitoring that position - and adjusting if necessary - becomes critical. Can Covered Call Tools help me to adjust as market dynamics change?
MS: Screening for new positions is only half of what we do. The other half is to help you manage your portfolio of covered calls via several portfolio management tools. We have tools to help you plan your strategy (Cover Me, Income Goal), monitor your positions (Dashboard, Summary), adjust your positions (Roll Me), and stay diversified (Diversify Me).
SA: How up-to-date is the pricing data on my portfolio? Is there an alerts system for when I’m not on Seeking Alpha?
MS: Our prices are updated during market hours, 15-minute delayed. We have a Daily Watchlist email that users can opt-in to. Each user creates his or her Watchlist of stocks they like. Then they set an ‘annualized rate of return’ threshold. We will email them (after the close) if any of their Watchlist stocks are offering covered calls that exceed their return threshold. It’s a good way to know when to write covered calls on stocks you already know you like (or already own). You do not need to be logged into Seeking Alpha to receive the Watchlist email each day.
SA: At some point my options will approach expiry. How can I know when it’s the best time to roll over to a new expiry date, or to just let my position expire?
MS: The most commonly used portfolio management tool is called Roll Me and it helps you figure out if you should 'roll' (modify) an existing position (meaning, buy back the call option you shorted and then sell another call option in its place, in an attempt to maximize the time premium you collect). It allows you to compare 15 different options at once, in an easy to use format, and see that differences in dollars and rates of return for each. Your decision to roll or to allow the position to expire depends largely on how you feel about the stock going forward, but also to some extent on what kind of time premium you could capture if you kept it, and we will help you with that aspect.
SA: The assortment of tools in the Covered Call toolbox is amazing. If you could show a potential user only one tool - the most valuable and most unique - what would it be?
MS: It’s a toss up between the screener and the Roll Me tool/calculator. Both have integrated earnings release dates and ex-dividend dates, which are unique. In addition, the screener makes it a snap to say “remove all covered call candidates with earnings before expiration”, or “I already know I hate XYZ, ABC, and DEF stocks; take them out of the results and don’t ever show them to me again”, as well as searches like “limit results to just ETFs”, or “only technology stocks with P/Es below 15”. On the other hand, the Roll Me tool shows you what happens to your $ profit and annualized return if you buy back your existing option and then sell any one of 14 related options.
SA: What about the Income Goal tool?
MS: You know, I almost said that one, too. Too hard to choose just one! The Goal tool allows you to state how much capital you have, what kind of monthly income you’re looking for, the number of open positions you want to have, and how much margin you are using (if any). It then calculates a set of trades that will help you meet your income goal. It tells you how many shares to buy and what net debit you should use when entering each trade. This makes it easy for people who are trying to achieve a certain monthly income goal from their covered calls. If you have a modest goal then it will show deep-in-the-money choices. And if your goal is a bit more aggressive then you will see more in-the-money and at-the-money choices showing up.
SA: Give us a couple examples of times where Covered Call has helped you or your clients make exceptionally good investment decisions.
MS: Well, I can’t really discuss client trades. But I can tell you that I monitor the Top 10 list each month and 8-9 of them (of the 10) are winners each month (and the losers have not been catastrophic), so I think the members are picking some good trades. I don’t know if the members are feeding off each other or if they’re all using the tool independently and ending up at the same stocks.
Half the battle of investing in covered calls is about avoiding risky situations. Our filters make it easy to remove choices that have earnings before expiration, are thinly traded (low open interest), are low value stocks (less than $5 or $10), are leveraged ETFs, or a variety of other things. By removing these from the set of results right off the bat, we are helping to keep you out of overly risky positions.
There are attributes beyond our control, though. It’s up to the investor to track proper position sizing and to stay diversified. And if they’re trading on margin they need to be extra careful. Like any other investment strategy, covered calls can be conservative but can also be abused to the point where they become excessively risky and dangerous. Our goal is to provide the definitive best-of-breed tools to help investors of all skill levels be successful with covered calls. Our two-week free trial makes it risk-free for anyone to check us out and see how the tools work.
Have any thoughts, suggestions, or comments for Mike and his team? Tell them, and other SA readers, what you think in the comment stream.