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JaysRage (90.44)

The importance of Velocity in Covered Calls in a Dividend Portfolio

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March 21, 2014 – Comments (16) | RELATED TICKERS: KRFT , GE , MCD

This is a follow-up blog to my newfound respect for a conservative dividend related portfolio, enhanced by an active covered call strategy.   A few staring assumptions....

1) You will need enough capital to be able to maintain at least 100 shares of a typical mega-cap dividend paying company.    Ideally, you will be managing a porfolio of 4-5 positions of this type.   A porfolio of around 40,000 and above can manage this strategy effectively.   You will likely need a minimum of approximately 10,000 to 12,000 to do this right. 

Since, obviously, you can't write a covered call if you don't have 100 shares in the company, because, um, otherwise, it's not covered. 

2) You will need to maintain a watch list of several eligible companies.   These companies are familiar names that everyone knows.   GE, KO, PG, KMB, JNJ, WMT, MCD   The companies should pay a solid dividend and be fairly stable.   Ideally, you don't actually want price appreciation to be more than 5-10% per year.   This stability will help to avoid having to reallocate called-out positions.   You should have at least 4 or 5 more options than number of positions that you are actually managing at any given time.

Now, doing it.....   

Now that you're ready to go, you can begin to allocate your positions.   Allocate in blocks of 100 shares.....in approximately similar $ blocks.   Feel free to more heavily weight a position with a stronger dividend or that you are slightly more bullish on.  

Then, write calls against the positions.  Only, don't do it as suggested by most covered call strategies that I have seen.   Do not take the 3 month call and write against it.   You will notice that velocity of call decay is not linear and by writing against the 3 month out call, you are only really getting velocity in 1 month out of three.  Yuk.   There are points where you can get more bang for your buck.  Take the current Kraft call tree

Say you have 200 shares of Kraft that you just bought.  

Mar 22 -- 60 = 0

April 29 -- 60 =  0

June 21 -- 60 = .15

Sep 20 -- 60 = .55

You sell two calls against this position for September 20 worth 110.   Expect to sell after 4 months, rather than letting it expire.   Repeat three times annually.   Boom.  330 against 11,000 allocated.    You've added 3% to your 3.75% dividend yield and are now yielding 6.75%.  After fees, it's closer to 6.5%,   

If you get called out, you sit at an annualized return of 15.85%

I literally took the first company off my list and ran it through the process.  There are stocks that are slightly more favorably positioned, and you can time things a little better.   I literally just took an average stock and put this together.   VERY EASY. 

The biggest key is you buy calls further into the future than you are usually taught and you sell them a couple of months before they mature.  For the last couple of months, these calls are virtually worthless.   You are losing valuable velocity with your money by letting them expire.   Buy them back for a couple of pennies and reapply your money.  

 

 

16 Comments – Post Your Own

#1) On March 21, 2014 at 3:54 PM, Mega (99.98) wrote:

Thanks for the example.

Your calculation doesn't include any cost for buying back the call in 4 months, say $20. That reduces the yield to around 2.5%.

Covered call strategies don't really generate that much extra return though. They mainly just convert expected capital gains to expected income. You have to give up upside to get that return. I believe as you actually implement a call strategy over several years (or backtest it) you will recognize that your returns are not as good as you hope.

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#2) On March 21, 2014 at 5:05 PM, JaysRage (90.44) wrote:

Yeah, that's because most people are doing it really really wrong.   They are literally giving up 1/3 of their projected income because they do not target the velocity fall portion of the call decay.  

You can doubt it all you want.   I just showed you how it's done.    This isn't my first option rodeo.   I've been writing naked calls for a long time.   I've just never coupled it with a dividend portfolio before.  

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#3) On March 21, 2014 at 5:06 PM, JaysRage (90.44) wrote:

I obviously pay less per transaction than you do.   I guess I have to suggest that you get a better on-line broker if you are  paying $20 to buy a call. 

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#4) On March 21, 2014 at 5:17 PM, JaysRage (90.44) wrote:

Here's the REAL reason that most people don't do this.   It isn't sexy.  They see $100 as picking up dimes against the 11,000 capital investment.   They get bored.   They get lazy.  They don't redeploy.   They are too good for that small stuff chump change.   They think they can do better looking for the rocket stocks.  I mean, geez, $100?  You can't take the family to the ball game with that kind of money, right?  Why bother, right?    

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#5) On March 21, 2014 at 7:12 PM, Mega (99.98) wrote:

"I obviously pay less per transaction than you do.   I guess I have to suggest that you get a better on-line broker if you are  paying $20 to buy a call." 

Not what I was saying. There aren't any KRFT options two months out, but if there were the $60 calls would trade around $.10 each, so $20 total. Your example assumed the cost to close the trade was $0.

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#6) On March 21, 2014 at 7:19 PM, JaysRage (90.44) wrote:

The curve would dictate that you might be looking at a couple of pennies.  

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#7) On March 22, 2014 at 3:31 AM, somrh (78.65) wrote:

@JayRage

A few comments (and FWIW, I reworked my table (x2) using your scenario; I can post those later if you'd like).

1) KRFT April $60 strikes aren't worthless (this was part of Mega's point); they just don't exist. You won't be able to buy them back at $0. (but these are 1 months anyway. Your strategy is 2 months remaining.)

2) Regarding transaction fees that Mega brought up; it's not just your broker fees. The bid/ask spread is also part of the transaction fee. That will reduce your returns on this dramatically. In your Kraft example, assuming they're worthless, at a bare minimum you would have to buy back for $.05 (we're still on 5 cent increments with KRFT, no?). But it will likely be higher than that. (I'll show that in a minute.)

3) You also must factor in price appreciation. If you're assuming 5% earnings growth per annum then every 4 months you should also assume, say, 1.67% price apprecation (give or take a few standard deviations). There's no reason to suppose the stock will be trading at the same price.

Here's what your scenario actually looks like (I'm assuming that implied volatility remains the same and the stock appreciates by 1.67%... YMMV still applies). This still ignores transaction costs and bid/ask spreads.

So you write the options for $0.55 and you have to buy them back (in 4 months) for $0.21. That gives you:

So $0.34 x 200 x 3 = $204.

Now you're down to about 1.8% and that hasn't factored in transaction costs.

Factoring in bid/ask spread, you'll probably have to write the option for $0.50 and buy back at $0.25 (give or take... and still ignoring broker fees) which brings this down to about $0.25 profit.

One last point, when you talk about "15.85% annualized return", that's a best case scenario. That's not the annualized return you can expect from the entire portfolio.

I still contend this portfolio will do about 6-8% w/o calls and maybe get an extra 1% or so more with calls. Again, YMMV.

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#8) On March 22, 2014 at 3:32 AM, somrh (78.65) wrote:

Oops posted wrong image. That's 1 year table... :)

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#9) On March 22, 2014 at 3:38 AM, somrh (78.65) wrote:

One last comment.

There's some interesting studies regarding the "implied volatility term structure".  I linked to them in this forum post. I think that strategy mainly works on shorter dated options (1M). The excess returns go away the longer you go out. I still haven't gone through the articles yet though :)

Also in that forum post I uploaded an experimental Excel add-in that allows you to calculate Black Scholes option pricing, implied volatility and Greeks. If you try it out and find anything goofy let me know.

It will be slightly goofy with dividends as I used the continuous dividend formula. So that will skew things a tad. 

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#10) On March 22, 2014 at 4:10 AM, JaysRage (90.44) wrote:

The June 60 is .15.....you're implying that the May one which doesn't exist, after another month of decay would be .21

Mega's estimate of .1 was at least somewhat rational.   The whole point that you guys aren't getting is that I am not locked into an exact time window for buying and selling my covered calls.  It is quite the opposite.  I'm encouraging maximizing that.   You're assuming that I'm going to be de-optimized.  

That's the last key to the puzzle.   You do not lock yourself into these time windows, which is the other failure of the typical three month approach and the last .75% that is missing.   It's just impossible to articulate in a practical example, because I can't show you when exactly that will happen.   I can point to it with different fixed option strategies and current state, but I don't have an actual decay curve where I can show you that it will touch a buy back point before the 3 month window and increase my velocity to resell the call for more cash.  That is why we're talking about a floor in returns.  There is potential for a great deal more velocity in call flipping here.    

I can set a long-term limit buy to ensure that this happens. I then increase my velocity even more than my worst case scenario and achieve exactly the returns that I have assured you that I can achieve.    

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#11) On March 22, 2014 at 4:10 AM, JaysRage (90.44) wrote:

The June 60 is .15.....you're implying that the May one which doesn't exist, after another month of decay would be .21

Mega's estimate of .1 was at least somewhat rational.   The whole point that you guys aren't getting is that I am not locked into an exact time window for buying and selling my covered calls.  It is quite the opposite.  I'm encouraging maximizing that.   You're assuming that I'm going to be de-optimized.  

That's the last key to the puzzle.   You do not lock yourself into these time windows, which is the other failure of the typical three month approach and the last .75% that is missing.   It's just impossible to articulate in a practical example, because I can't show you when exactly that will happen.   I can point to it with different fixed option strategies and current state, but I don't have an actual decay curve where I can show you that it will touch a buy back point before the 3 month window and increase my velocity to resell the call for more cash.  That is why we're talking about a floor in returns.  There is potential for a great deal more velocity in call flipping here.    

I can set a long-term limit buy to ensure that this happens. I then increase my velocity even more than my worst case scenario and achieve exactly the returns that I have assured you that I can achieve.    

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#12) On March 22, 2014 at 11:20 AM, JaysRage (90.44) wrote:

You have to remember that in the covered call situation, you are essentially shorting your own stock for a premium.   If you aren't getting the call decay that you need, it's because your stock is appreciating.   If your stock appreciates and an unexpected rate, you will be able to close the entire matched set for a profit and reposition with a different equity if you desire.   There is actually a great deal of flexibility.  What I have tried to show you is that just moving the window is worth a great deal of additional percentage gain.   The rest of the optimization is going to be curve behavior dependent.   

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#13) On March 22, 2014 at 7:13 PM, somrh (78.65) wrote:

The June 60's have a bid/ask of 0.15/0.25. So technically they're a tad higher.

Yes, the 2 month option should be worth less than the 3 month, all else being equal. I assumed price appreciation (with your 5% per annum assumption). So you got some delta effect counterbalancing the theta effect.

Maybe you can enhance your returns by timing it, etc. I don't know.

But your strategy (without any optimization) actually doesn't do any better than simply shorting a 4 month call option at the same strike (at least for this example). Using the same implied volatility as your Sept 60's I got a price of $0.35 for 4 month options. That's equivalent to the mechanical strategy I suggested above.

But your enhancement would have to outpace the transaction fees to make it worth your while (including bid/ask spreads). Personally I'm lazy and typically just let options expire on their own. It requires less work and I don't have to worry about whether or not I can counteract the transaction fees. 

Yeah, I understand what you're saying regarding the call/price appreciation tradeoff. That was part of my objection in the other thread. I contended that you can't just add the growth term to the call premiums because they will conteract eachother to an extent. So maybe you'll get dividends + growth + dampened calls or something like that. That's why I sitll think it won't be much better than say 6-8% stocks + 1-2% for calls.

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#14) On March 24, 2014 at 9:36 AM, JaysRage (90.44) wrote:

At the beginning of the blog, I laid out some of the assumptions of this theory and put some of the minimums for positions held.   If you have a larger portfolio, this also breaks down a little.   If your blocks of holdings get too big, you lose some flexibility with getting in and out of call positions.    If you are dealing with just a handful of calls for each position, it's no big deal, but if you're trying to dump 20 calls, you'll be less optimized, because you'll likely have to split any move into partials.    If you are in 20-30,000 blocks of positions, you will not have any difficulty in that regard.   However, you can't just keep using different equities either.   There are really only 20 or so equities that are going to work here, so this strategy is probably going to de-optimize at a position of around 400,000.  

Despite all these charts you see, decay is not linear.   You don't need a position to go down and stay down in order to achieve velocity.   You just need it to touch you limit. 

I understand that people can get queezy about transaction fees as a percentage of a transaction.   It's a mental block regarding margins.....I understand it because it used to bother me until over time I was able to re-wire my brain to focus on the net.    If your net is worth the move, you do it.    Eventually you train your brain to look at the net, not at the margin of the particular transaction. 

(80-20)*6  > (120-20)*3

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#15) On March 24, 2014 at 11:59 PM, BlueCollarTrade (42.79) wrote:

JaysRage,

How long have you done this covered call strategy or is this the next step in your investing evolution?  What is your actual track record?

I am not trying to call you out at all, but just curious.  I personally do not like covered calls due to capping my upside potential, but do like the opportunity to create income.    I have mixed results at best using covered calls on stocks that pay dividends.    However, I do feel the need to sell something, so I am experimenting with Ratio Spreads right now. 

An example of a Call Ratio Spread(1 by 2 or 2 by 3) is where I buy 1 in-the-money call or 1 at-the-money call, and sell 2 out-of-the-money calls for a credit.   I am net short call like I would with a covered call, but the way the Ratio Spread is structured, I will make more money at expiration if the stock closed at the OTM short strike, then with just a covered call.    If this sounds confusing, it is because I am terrible at explaining it and I probably need to go to bed.   

Good Luck!  

BCT 

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#16) On March 25, 2014 at 9:59 AM, JaysRage (90.44) wrote:

I don't know if it's an "evolution" in my investing, but, rather, a portfolio fit that works in a different risk segment with different goals.  I have had the luxury to this point of having complete autonomy on my investing portfolios and great deal of time to spend researching.   I also have a tolerance for the significant variances and risk that can come with small cap and international investing.  

I am now in a situation where I will be managing investment portfolios in cooperation with or under the goverance of entities with a lower risk tolerance than myself and with income as primary objective of the investment vehicle, so I have been forced to build portfolios that meet their risk tolerance, which is much small than mine.    I have found that this approach is a nice mix of return and income with dampened risk.   I have been managing a portion of my personal portfolio like this as a pilot for 7 months, and I have a 15% annualized return vs a 9% market return, and I have been thrilled with the relative simplicity that it can be maintained.  

I have enjoyed the give and take on my two threads.   I was partially fishing for huge holes in this investment strategy, and while there were some good and valid criticisms, I also feel that there was a great deal of validation of this strategy as a workable model for some of the things that I am looking to do. It has been good for me to be forced to look at downside risk and income as parameters of an investment vehicle.   I see this as another tool in my toolbelt for building a portfolio. 

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