Long term investing and the logics of selling options

[PandaBear]

This is strictly an educational question from me. Say, I'm an investor who has a VERY LONG horizon (i.e. 30-50 years) and typically hold onto stock that I have confidence in due to my own domain knowledge (in Tech stock), and most of my 401k / IRA are in S&P500 ETF like Vangard.

Recently I am looking at other investment choices and I saw someone mentioned a strategy of holding a "stable" stock you understand long term, while selling covered call options on the side to get extra income. The example he uses is McDonald's stock: while holding it he would sell call options at a higher strike price, hoping that it would not be exercised when expired. He claims that this would typically add 2-5% extra return to his holding at the risk of the stock going significantly higher than the difference, and the loss would still be limited to the extra of his option's price. Another strategy he mentioned is the use of rollover of put options he sold if it goes down, to use time to dilute his "loss" if it exceed his price.

Fundamentally he said options is a zero sum game in the long run and there's more demand for buying options than selling options, so overall you can make money in the long run selling options (with stop loss to protect yourself) in a controlled manner. However, I wonder if it is really true as that would mean most long term investors would have done it also, rather than just holding stocks and minimize fees like using ETF funds.

Has anyone here use these options strategy in a long term portfolio? What are your opinions on this?

 

[ArrestMeRedZ]

I had a managed account employ this strategy for the stocks they picked. The problem was the market was rising so fast after a while they abandoned selling covered calls.
I only used them for a couple of years. I decided I could do better with ETFs and carefully selected stocks and mutual funds. The covered call strategy was good in a normal market, I just didn't like someone making choices for me.

 

[MRC01]

Plenty of advice & instruction on this topic online, and you should seek out varying professional opinions on this. Years ago I used to trade options, it was fun, educational and profitable. But like @ArrestMeRedZ , over time I realized I could do just as well with other investments that are lower effort. And there are funds like SPX that you can trade instead.

Options are a form of insurance, and you can buy it or sell it. They can reduce risk, or increase it, depending on the kinds of trades you do. Your example is selling calls on stocks you already own. This generates income, but the cost of that income is that you forgo any gains beyond the strike price. Before doing this, know that stock value increases and decreases are rarely predictable nor linear. So a strike price that sounds safe may not actually be when you consider volatility.

Black and Scholes devised a method for computing the "ideal" price of options and they eventually got a Nobel Prize for their work. It involves the stock price, strike price, expiration date, volatility and interest rates. It's not perfect but can be a useful guide and many stock trading sites provide this as a reference for traders. Even though no model is perfect, the difference between theory & reality is bigger in reality than it is in theory, studying that model will increase understanding of options and how to trade them safely and effectively.

 

[ecotourist]

I friend has been selling call options and says he and his wife have been doing quite well using that strategy.

I've read up on ETFs or mutual funds that employ that strategy. Over time they don't do as well as comparable investments that just hold long investments. It seems they miss out on occasional big gains which more than offset the small regular gains.

It might depend on the market. If you knew that stocks would be going nowhere, selling call options might work pretty well. But the problem is you can't know that.

It's often said that most of the gains in a year are made on a very few days. You'd have to hope you didn't sell call options that spanned those few days.

 

[PandaBear]

I think I understand better now. The possibility is there, the lost in the big gain is there, and eventually things would fall into place to balance the equation. I guess you really have to know something that others don't to use this strategy (i.e. either in the industry or have some insider info). It looks like a strategy that's too complex for a nothing burger.

 

[Pablo]

I LOVE selling covered call options. It's a great strategy if for sure YOU don't want to sell the underlying stock before the expiration date and are ok with selling at the strike price before or on the expiration date. That's just part of it, and in general I have almost always made money at it.

I won't go into it here more. PM me and I will recommend some books.

I will tell you this about weaknesses:

1) Good luck finding decent premiums. The spreads can be wide and fluctuating but it's all machine driven.
2) If the stock dives and you want out, the option mostly likely will be cheap, but you need to buy to close
3) It's time consuming to some extent.
4) As you mentioned, your gains are completely capped. Sometimes I will just buy 5 contracts if I own 1000 shares as an example.

 

[zzyzzx]

I do this all the time. You just have to not care if you own the stock.

 

[John105]

To me it's about leverage and gamesmanship. I've always thought the simplest transaction of all, is to buy something. To do so, you need some sort of funds, most of the time the money equal to the transaction. Sure, there's margin but the interest rate is always unreasonable (house wins).

With options, you don't need the money to buy the stock. Also, there is a gambling aspect to it, which many enjoy.

One can set conditional buy and sell orders for stocks they own or don't own.

At any rate, imho risk increases when trading options. There seems to be a perception there is no risk, or that it's free.

One thing that I was told never to do, but I did put my hand on the stove with, was to short Union Carbide. That is a scary situation to be in. Imagine shorting google or facebook--how many months of pain would a person have endured to date, if their position is still needing to be covered, today?

 

[SC Maintenance]

I have been looking in to covered calls. It does look like a lot of work for a pretty marginal return. Most of the call options I have been looking at pay only a few pennies and don't need to be very far out of the money - like 3% out of the money pays 8 cents on a $120 stock. So I haven't. If you have a LOT of shares, or maybe a unique stock then it might make more sense to me.

Exactly what equities are you looking sell calls on. I imagine some stocks are better than others for this strategy.

 

[Pablo]

To me it's about leverage and gamesmanship. I've always thought the simplest transaction of all, is to buy something. To do so, you need some sort of funds, most of the time the money equal to the transaction. Sure, there's margin but the interest rate is always unreasonable (house wins).

With options, you don't need the money to buy the stock. Also, there is a gambling aspect to it, which many enjoy.

One can set conditional buy and sell orders for stocks they own or don't own.

At any rate, imho risk increases when trading options. There seems to be a perception there is no risk, or that it's free.

Some incorrectness here. Based on myth, lack of knowledge.

Covered calls by the very name, you must own the stock. Selling put options - you are looking to buy the stock (at lower price - hopefully)

Using options properly is the antithesis of gambling. Certainly no more than buying any stock.

Using covered calls almost always decreases risk.

What you are referring to are typically called naked options, and well can't do that in an IRA, or with out sufficient margin (or cash on the side)

But yes the more risky thing is shorting a stock, because if the stock goes to the moon - well you be toast.

 

[zzyzzx]

Exactly what equities are you looking sell calls on.

Stocks that I don't care if I own them. As in right now that would be anything that doesn't pay a dividend or good enough of a dividend (because I am old), or anything cyclical (because I suspect that an economic downturn in imminent).

Also, if selling covered calls I would never do that when they are going to announce earnings, meaning I want the options to expire before the next earnings call date.

 

[John105]

Some incorrectness here. Based on myth, lack of knowledge.

Covered calls by the very name, you must own the stock. Selling put options - you are looking to buy the stock (at lower price - hopefully)

Using options properly is the antithesis of gambling. Certainly no more than buying any stock.

Using covered calls almost always decreases risk.

What you are referring to are typically called naked options, and well can't do that in an IRA, or with out sufficient margin (or cash on the side)

But yes the more risky thing is shorting a stock, because if the stock goes to the moon - well you be toast.

I'm gonna disagree, but it wouldn't be the first time and I've got thick skin.

 

[Pablo]

I have been looking in to covered calls. It does look like a lot of work for a pretty marginal return. Most of the call options I have been looking at pay only a few pennies and don't need to be very far out of the money - like 3% out of the money pays 8 cents on a $120 stock. So I haven't. If you have a LOT of shares, or maybe a unique stock then it might make more sense to me.

Exactly what equities are you looking sell calls on. I imagine some stocks are better than others for this strategy.

That's why I just don't spend as much time on it as I should. The gambling part if we stick with that theme.............should I even bother checking the options...

Then when I do...........

 

[John105]

Some incorrectness here. Based on myth, lack of knowledge.

Covered calls by the very name, you must own the stock. Selling put options - you are looking to buy the stock (at lower price - hopefully)

Using options properly is the antithesis of gambling. Certainly no more than buying any stock.

Using covered calls almost always decreases risk.

What you are referring to are typically called naked options, and well can't do that in an IRA, or with out sufficient margin (or cash on the side)

But yes the more risky thing is shorting a stock, because if the stock goes to the moon - well you be toast.

What is toast, baked bread?

When one buys a stock, such as Rivian, the most one can lose, is 100% of their investment. When shorting a stock, there is no limit to the loss, the transaction needs to be covered eventually. Again, I would wonder, do people play that game, because they don't understand, or because they enjoy the risk that is not capped? Covered calls are capped, and yes you must own the stock.

One thing I would have to say, not just with money, romance, cars, life. Be careful taking advice from strangers one does not know.

I would love for someone here, to explain to me, how I reconcile the vmWare takeover by Broadcom. Because of it, I have no tax refund this year, a first in over 20 years.

 

[SC Maintenance]

I'm gonna disagree, but it wouldn't be the first time and I've got thick skin.

I don't think you understand a covered call.

Your selling someone the right to purchase a stock you already own at some price, within some period. For example, I have a share of something worth $100. I sell a call to you to buy it at $102 in the next 30 days, for say a dime.

If you don't buy it, I make a dime.

If you do buy it, I make my dime plus the $102

If the stock falls and I want to sell, I need to buy out the call first - which at that point will be less than a dime anyway (further out of the money)

Literally the only gamble I took is if the stock goes above $102, then I missed out on that gain. The only other downside is all the time involved for a minimal gain.

 

[SC Maintenance]

Stocks that I don't care if I own them. As in right now that would be anything that doesn't pay a dividend or good enough of a dividend (because I am old), or anything cyclical (because I suspect that an economic downturn in imminent).

Also, if selling covered calls I would never do that when they are going to announce earnings, meaning I want the options to expire before the next earnings call date.

Ok, let me ask a different way.

What is the value of the call your looking to sell, vs the price of the stock?

Per Pablo's post - the payment for a call option these days is virtually nothing.

Sell the stock and buy one you like that pays a dividend?

 

[Pablo]

What is toast, baked bread?

When one buys a stock, such as Rivian, the most one can lose, is 100% of their investment. When shorting a stock, there is no limit to the loss, the transaction needs to be covered eventually. Again, I would wonder, do people play that game, because they don't understand, or because they enjoy the risk that is not capped? Covered calls are capped, and yes you must own the stock.

One thing I would have to say, not just with money, romance, cars, life. Be careful taking advice from strange one does not know.

I would love for someone here, to explain to me, how I reconcile the vmWare takeover by Broadcom. Because of it, I have no tax refund this year, a first in over 20 years.

Toast = you are done. Fini. We agree. No limit...........toast...............

be toast​

1. To be in serious trouble; to be ruined, finished, or defeated. If Mom and Dad find out we took their car out last night, we're toast! Down by 45 points with only two minutes left in the game, it's pretty safe to say that the home team is toast at this point.
2. To be completely broken, wrecked, or destroyed.

 

[drtyler]

Toast = you are done. Fini. We agree. No limit...........toast...............

be toast​

1. To be in serious trouble; to be ruined, finished, or defeated. If Mom and Dad find out we took their car out last night, we're toast! Down by 45 points with only two minutes left in the game, it's pretty safe to say that the home team is toast at this point.
2. To be completely broken, wrecked, or destroyed.

I think you got it right in the first line of post #10.

 

[John105]

I don't think you understand a covered call.

Your selling someone the right to purchase a stock you already own at some price, within some period. For example, I have a share of something worth $100. I sell a call to you to buy it at $102 in the next 30 days, for say a dime.

If you don't buy it, I make a dime.

If you do buy it, I make my dime plus the $102

If the stock falls and I want to sell, I need to buy out the call first - which at that point will be less than a dime anyway (further out of the money)

Literally the only gamble I took is if the stock goes above $102, then I missed out on that gain. The only other downside is all the time involved for a minimal gain.

Would this be true.

With owning a stock, maximum loss is limited (100%), and maximum gain is unlimited.

With a covered call, maximum loss is limited, and actually reduced by a premium collected. Maximum gain is limited.

What if the stock goes up above the strike? Don't we buy stocks wanting them to go up? Again, if we buy an extended warranty on a vehicle, are we happy like Dougie, that it broke down a lot?

OP has a 30-50 year horizon. That's a really long time, and many stocks will go up, not down, not sideways, in that period of time.

imho the covered call works best if his stocks go sideways. Not down, not up.

 

[SC Maintenance]

Would this be true.

With owning a stock, maximum loss is limited (100%), and maximum gain is unlimited.

With a covered call, maximum loss is limited, and actually reduced by a premium collected. Maximum gain is limited.

What if the stock goes up above the strike? Don't we buy stocks wanting them to go up? Again, if we buy an extended warranty on a vehicle, are we happy like Dougie, that it broke down a lot?

OP has a 30-50 year horizon. That's a really long time, and many stocks will go up, not down, not sideways, in that period of time.

imho the covered call works best if his stocks go sideways. Not down, not up.

Yes, I clearly stated one of the downsides is your limiting your upside gain.

You sell a covered call for a short period of time - 30, 60 or 90 days. Your limiting your upside in that period of time. So the whole 30 to 50 years is irrelevant.

All the the other things you mentioned are strategies - like do you want to limit your upside, what stocks to sell calls on, etc. . Do you want to generate a small income from an asset you own in exchange for limited near term upside gains. That's the question. The risks are clearly spelled out, unlike a naked option.