For investors interested in using options, it's important to understand the underlying stock as well as the strategy in question.
In this segment from Motley Fool Live that first aired July 9, Motley Fool Canada analyst Jim Gillies, Motley Fool Options advisor Jim Mueller, CFA, and Fool.com editor/analyst Ellen Bowman discuss whether it makes sense to sell shares using covered calls.
Ellen Bowman: Catherine is asking, "What's the average amount of income you make on covered calls for retirees with large pre-tax accounts? Are covered calls a good strategy for trimming positions?"
Jim Gillies: I'll answer the last one first because it's quick. I'm of the opinion, if you want to trim a position, just sell the shares. Don't get fancy.
Ellen Bowman: Oh, I didn't expect that. I thought you might say keep getting paid while you're waiting to sell.
Jim Gillies: My viewpoint is, if you've decided to trim, you do not want the upside or the downside of those shares. By selling every call, you've given away your upside, so you've accomplished that, but you still own the downside.
Ellen Bowman: True, so if you're ready to exit. That's how you make a decision.
Jim Mueller: Yeah. If you're ready to exit, just exit. That's my opinion. Others do use covered calls as a way to get out and being paid while they're waiting. Similarly, they use puts as a way to get in at buying shares, selling a put and getting paid while they wait.
Jim Gillies: Yeah. The problem Ellen is quite often what happens. If the universe conspires against you.
Ellen Bowman: It does, yeah.
Jim Gillies: If the universe conspires against you. You'll sell a covered call, I want to get out of this share. I want to get into the stock, so I'm going to trim it. I'm going to sell and at the money covered call, let's say, pays me five percent of the share price. Don't look at me, I'm going to get out at five percent effectively higher, the stock then falls 20 percent.
Jim Mueller: Yeah, but you still own the shares.
Jim Gillies: Yeah, you still own the shares. Yeah, you keep the five percent of the premium.
Jim Mueller: As far as the yield, how much you can earn, we target one percent per month on the share price for each call. So on a Starbucks position that costs you $11,000, we want to be paid at least $110 per month, so 330. We want to be paid, that call, we want it have priced at 330 or better for a three-month call. 330 off of $11,000 is one percent per month, or three percent over the month. If you can do that over and over and over again, that's 12 percent over the year. If you do that on several positions
and ladder them so that you have one or two or three expiring every month because options come in three different overlapping cycles of three months, then you can have a steady stream of income that can potentially generate a fair amount. I have a long time target from selling options of generating 10
percent of the portfolio's beginning of the year value each year from that income, and I've managed to hit it a couple of times. I usually come in around 6-7 percent, eight percent sometimes. I've managed to hit it a couple of times. I'll probably hit it this year. It's a nice target, but it's a loose target and I'm not
going to really pound it, pound it. try to get into it because that introduces too much risk. But 4, 5 percent, 6 percent of your portfolio's starting year value is a reasonable target that you can generate in a given year. That boosts your returns on the portfolio or gives you a nice stream of cash. If it's done in a taxable account, it is short-term capital gains though, so [laughs] keep that in mind.