Does Living Off Covered Calls Really Work?

Selling covered calls can generate income of roughly 2 to 12 times that of dividend income received from the same stocks. Living off traditional investments has become challenging since the real yields from both stock dividends and bond interest are low, leading investors and retirees to consider covered calls.

Is living off covered calls is feasible? Income from covered calls varies but a 15% annual yield is realistic. This equates to estimated covered call income of $75,000 a year on a $500,000 stock portfolio, for example. Living off covered calls, then, could work for someone whose annual expenses are under $75,000 a year.

Over ten years ago, I sold my first covered call, and I’ve sold hundreds of covered calls since then.
Here I’ll share why living off covered calls alone can be challenging, and some solutions if you’re considering this often overlooked but sensible income stream used by financial advisors, fund managers, and more advanced investors.

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Is Living Off Covered Calls Possible?

There are seven main factors in determining if living off covered calls might be a good “option” for you. (I couldn’t resits the pun.)

I’ll write about each of these factors in more detail below. Several of these factors are rarely mentioned by covered call promoters, yet they are crucial to keeping your covered call income flowing consistently and your investment risk under control.

The factors range from lifestyle to advanced investing topics, like the VIX and market direction. They are:

1. The amount of capital allocated to covered call writing
2. The lifestyle expenses you need to cover while living off covered calls
3. Whether the stock market is headed up or down
4. Whether you’re willing to sell short in down markets
5. If you want to commit the time to manage covered calls
6. The Volatility index for the stock market
7. The logistics of living off covered calls

The Amount of Capital Allocated to Covered Call Writing

The amount of covered call income you’re able to generate will vary based on several factors, particularly the amount of investment capital, the strategy used, and the frequency with which call options are sold.

Let’s say that you have a nice round million dollars allocated to your investment portfolio. Of that amount, you’ve chosen to allocate $500,000 to covered call strategies.

Covered call income realistically ranges from 6% to 24% or more annualized, depending on the movement and volatility of the underlying stocks. This means that for a $500,000 stock portfolio, covered call income estimates can range from $6,000 to $24,000 a year.

Therefore, one percent covered call monthly income is a conservative estimate. In this case, living off covered calls could work for you if $5,000 a month covers your expenses. Similarly, someone investing one million in a covered call strategy could ideally generate $10,000 a month from selling covered calls.

The Formula for Covered Call Income

Here’s the simple math for selling covered calls on half a million dollars worth of stocks expecting a 1% per month return from the covered calls.

$500,000 x .01 = $5,000 Income Per Month

You’ll quickly see the advantage of selling covered calls by comparing the estimated covered call income of 12% to typical dividend income from the S&P 500 index with its historical average dividend yield of about 1.77% annually. As you can see, selling covered calls can be a game changer for retired stock market investors with insufficient retirement savings.

Let me clarify: this is investment income that you’ll collect in your brokerage account for selling call options against your stock holdings. This is the essence of covered call writing.

If you’re trying to live off covered calls, there are a few important variables to consider. Let’s address those next.

Covered Call Income Booster

First, selling covered calls on dividend stocks or income generating ETFs can significantly increase the income from a covered call strategy. Switching from growth to income stocks requires a mental shift for many stock investors but dividends can provide income when covered calls aren’t being sold against stock positions as explained ahead.

Taxes on Covered Calls

Income taxes offset covered call income for most investors since covered call income usually consists of short term capital gains on the options sold. Often options simply expire worthless vs being sold. I personally like selling covered calls 4 to 6 weeks out but everyone can choose what works best for their own schedule and income goals.

Covered Calls in an IRA or 401k

Covered calls are a conservative option strategy; so much so, covered calls can be sold in most retirement accounts, thereby delaying or avoiding taxes on the covered call income.

There can be a problem selling covered calls in retirement accounts, however. If you’re trying to live off covered calls, you’ve got to withdraw money from the account to pay the monthly bills. If you’re making mandatory retirement withdrawals from the account anyway due to your age or an inherited IRA, taxes are less relevant, however, since you’re making RMDs anyway.

Living Off Covered Calls Vs Account Withdrawals

I don’t know about you, but I don’t like making withdrawals from retirement savings following something like the popular 4% rule. It’s just too hard to know how much you need to retire and predict the longevity of both your life and your retirement savings for me to rely on retirement withdrawals for, optimistically, 30 years.

Note that the goal of living off covered calls is to live off income from investments, instead of withdrawing investment capital. Generating income to avoid, delay, or lower amounts being withdrawn from investment savings as much as possible is a core principle here at Retire Certain. This approach is mandatory for those with insufficient retirement savings who don’t want to cut expenses excessively.

As you can see, selling covered calls can be a good way to increase income before retirement or even in retirement for stock investors.

There’s a lot more to consider before you retire with a plan of living off covered calls, however, so keep reading.

Expenses You Need to Cover When Living Off Covered Calls

It’s easy to get excited about higher income investing strategies and overlook the obvious and somewhat deflating topic: expenses.

The focus of this post, however, is to see if living off covered calls is feasible. This means that your lifestyle expenses will determine if you can live off covered calls as much as the income that can be generated from selling covered calls.

Knowing this, you’ll want to carefully review your expenses to ensure they are in alignment with your priorities. This is usually clarified from an overall financial plan as taught in my investing course.

Do Covered Calls Work in Bear Markets?

Market direction is probably the most important (and little mentioned!) income disruptor when attempting to live off covered calls.

Covered calls are a sideways or a bull market strategy.

This is because:
1. You must own the “underlying” stocks to sell covered calls
2. You typically sell call options with strikes near or greater than the stock cost
3. If the strike price is less than your cost, you risk your stock getting called at a loss

Solutions for Living Off Covered Calls During Bear Markets

Are there ways to work around this covered call bear market dilemma? Sure, more advanced investors and financial advisors sometimes use the following strategies:

Buy protective puts on the underlying stock
Sell indexes that short the market during bear stock markets (which is not something I do)
Create diversified income streams that will cover expenses when stocks go down and covered calls won’t work
Sell call options on a more actively traded defensive tactical portfolio so there is probably always at least one asset increasing in price
Increase cash as stocks become more overvalued in bull markets

Selling covered calls during bull markets is relatively simple. Even investors that usually buy and hold stocks can sell out of the money call options for extra income with very little effort and a meaningful improvement in income from stocks. This can be an ideal strategy for older investors that have owned one stock for a long time and don’t want to sell their shares.

During bear markets, however, things get more complicated as you can see. A couple of these defensive covered call strategies might work well, however, if you are willing to put in the effort to learn and implement one or more of these solutions above.

It’s my opinion that selling protective puts is the simplest way to protect covered call positions from declines, although buying puts offsets the call income a bit; the put is like having insurance on your stocks, and insurance cost money.

If you’re planning on living off covered calls, however, and a bear market occurs, your source of income can get very threatened without one of these advanced strategies. This can be very problematic, especially for those in retirement that don’t want to live on withdrawals.

Here’s my own workaround for this. I like diversified income streams that work during different economic and stock market cycles. Bear markets are going to occur for stock investors. It’s not “if” a bear market is coming; it’s “when” will the next bear market occur. The question is how can someone living off covered call income most of the time cover those months when covered calls cannot be sold profitably?

I personally found the solution to be having other forms of income.

Covered Call Popularity

Note that the closer we move toward the end of bull market cycles, the more popular covered calls become. Then after a huge bear market, when stocks are cheap, and covered calls are more likely to succeed, covered calls become less popular due to investor emotions.

Fortunately, stock markets go up and sideways much more often than they go down, making the odds favor stock investors. This means the markets usually favor covered call writers, too, but selling covered calls is trickier than simply owning stocks during bear markets as previously explained in the bullets above.

Since the overall direction of the broad stock market affects the price of most stocks, it has to be considered by any investor wanting to live off covered calls. Investing in stocks has risk, period.

Selling Short During Bear Markets

You probably already know that the S&P 500 index is based on owning (being long) the 500 companies in that index.

There are also ETFs and funds that sell short the stocks in the popular indexes. This can seem complex, but, basically, investors buy the index that sells the stocks (called shorting) when using a short index strategy. When you sell a security that you don’t own, you are selling short.

I only mention short stock funds because they can be a solution to the inability to sell covered calls during bear markets. There are, however, several serious caveats.
1. It’s impossible to know the exact timing of market cycles
2. You must accept that you may get whipped around a bit as the cycles change
3. Volatile short cycles happen during longer market cycles

Selling short can feel scarier than owning stocks outright and with good reason. Over time, we all know that the bias for the stock market is to trend upward. It goes up for a few years, then stocks drop, usually to a level higher than the last stock market decline. While there have been extended periods of negative stock market performance, overall, over time, the stock market increases in value.

I personally don’t feel it’s worth the risk to buy indexes that short the market; the strategy is too advanced for most investors. This means investors trying to live off covered calls will want to find other solutions for the lack of covered call income during bear markets.

Managing Covered Calls

Dividend income from stocks is passive. Covered call strategies are not as passive, however.

Having clarified this, I’ll write that a few years ago, I managed my covered call account while on a family vacation in a remote area of Italy with poor internet. It took little effort or interference.

Ideally, when selling covered calls, you’ll simply buy a stock, sell out of the money call options, and the options get exercised. It puts a smile on my face just to type that perfect covered call scenario. This results in easy income during a bull market once you learn the strategy.

The reality is that not all the options you sell get exercised by the option buyer so you end up managing positions.

The good news, however, is this: Just like there is a bias for the stock market to move up, there is also a bias for options to not get exercised, depending on the covered call structure.

Also, option value declines as the expiration date nears, which is a powerful dynamic for option sellers, and covered call writers are option sellers. This significantly tilts the probability in your favor when you’re selling covered calls. This is another reason I like covered call writing.

On the other hand, when an option doesn’t get exercised, you continue to own the stock, and it has to be managed if you want to continue getting covered call income. There are a number of steps you can take when a call option isn’t exercised.

What To Do When Covered Calls Aren’t Exercised

I always evaluate the stock chart before deciding how to proceed when a covered call isn’t exercised. The primary reason I own the stock or ETF also affects the actions I take to manage the position. In other words, did I buy the stock only for covered calls or am I happy to own the stock for dividends or capital gains potential?

Usually, you can just sell another call option and collect the income when a call option is not exercised. In this case, the stock remains in your covered call pool of stocks, at least until option expiration.

If I own a dividend paying stock bought as a longer term holding that’s moving sideways, I just watch the stock and sell a call when the stock is around the price I paid or near the top of a technical pattern. This adds a little income here and there. This works especially well with dividend income stocks you are happy to own anyway.

Alternatively, covered call writers can simply sell the stock without selling another call immediately when an option isn’t exercised.

Oftentimes, covered calls are rolled when the covered call writer doesn’t want to sell the stock to the call option buyer. This adds another level of management.

Which step you take depends on your covered call strategy and income goals. You can see how covered call strategies must be managed since not all covered call options get exercised.

Accept that management of stocks that don’t get called away is a part of covered call writing if you want to try living off covered calls. This is a reality of covered call writing.

Accounting for Covered Calls

As far as management, accounting also must be done to track the results of your covered call selling. You can download trades off most brokerage platforms to make this easier.

While the accounting aspect of covered call writing can be boring, having the adjusted cost basis for any stocks that don’t get called away will be necessary for making profitable management decisions.

This isn’t a huge task, but it is one that will need to be done to maximize and measure results from selling covered calls.

Also, if the goal is living off covered calls, knowing the results you’re getting from your efforts is crucial to managing cash flow and planning for your future.

The Volatility Index for the Stock Market

While this may seem counter intuitive, being able to live off covered calls is more likely during times of high uncertainty. This is due to the Volatility Index. Let me explain.

Higher Covered Call Premiums

The prices of options increase during volatility. This is because there is more risk given the higher uncertainty. Therefore, a covered call writer will be able to get higher premiums, or income, from selling call options during such uncertain times.

Covered Call Risk During Bear Markets

Shortly after the bear market of 2008, it was easy to sell call options for 3% of the value of higher quality underlying stocks, for example. Volatility decreased, however, into the extended bull market. Near the money covered call premiums that are 4 to 6 weeks out of 1% to 2% are often the norm for high quality stocks, however, especially during low volatility times.

While you can make more covered call income during high volatility times, the offset to higher premiums is presumably more risk; your underlying stocks will have more perceived risk by investors.

Stock Investing Psychology

Let’s question this risk perception, however, and how it relates to someone trying to live off covered calls during all market cycles. As investors, maybe we can use it to our advantage because risk perception is often related to emotions instead of more reliable logic, historical data, and math.

Let’s ask: Was there more risk in the stock market in mid 2007 or in March of 2009 after stocks had bottomed? There was clearly more risk before the S&P 500 fell more than 50% during the bull market from late 2007 to March 2009 than after the market fell.

What was the probability it would have fallen another 50% from March 2009 prices? I would say the odds were pretty much zero. (And if it did fall by another 50%, our last concern would be our covered calls since it would indicate utter financial crisis.)

An investor could have made some very good covered call income based on a minimal knowledge of stock market cycles, value investing, and the simple logic behind the perceived risk and stock prices. She could have sold covered calls in the 3% range and higher on stocks for several years after the bear market since there was a lot of fear and uncertainty as the financial crisis finally got sorted out. (Scroll down to watch a video on this.)

Yet the stock market moved up after March 2009. Since covered calls are a bull market strategy, near the money or out of the money covered calls would have worked brilliantly throughout the subsequent bull market. The easy high premiums, however, would have diminished as fear and uncertainty decreased over the years until concern over the next impending bear market grew.

There’s one major catch to this covered call strategy working so keep reading.

Capital for Covered Call Stocks

Covered calls would have only been feasible during the bull market, however, if investment capital had been insightfully put aside or if you had an influx of income or capital to put into undervalued stocks after the bear market. If you were living off covered calls prior to the bear market, some or all of your capital would have likely been tied up in stocks that were bought at higher prices.

If all investment capital was tied up in such stocks going into the bear market as stocks fell, and you didn’t have access to more, you wouldn’t have been able to buy more stocks for covered call writing.

As the market fell, covered call income would have been much harder to generate since market prices, and thus strike prices, would have been below your cost. You can sell call options below your cost, but they require much more management, and you can get called out at a loss.

Diversified Income Streams

Bear markets are the dilemma for someone living off covered calls and why I like multiple sources of income diversified among paper assets like stocks and bonds, plus real estate or online businesses. Some income strategies work during some years, while others don’t. Ideally, you always have several income sources that flow in regardless of the financial markets or the economy, and some assets that at least maintain their value, too.

My husband, on the other hand, after decades of trading professionally, loves hedging and more complex trades that don’t rely on market direction to work. He teaches how to hedge covered calls in his beginner options course.

I personally prefer simple investment strategies, so we work well together. Covered calls generate simple, “mostly” passive income.

The Logistics of Living Off Covered Calls

One of the nice aspects of covered call selling is that getting paid is simple.

How Do You Get Covered Call Income?

A lot of people compare covered call writing to collecting rent from real estate.

In the same way that you own a property from which you collect rent checks, you own stocks from which you collect call option premiums.

To get paid, you simply sell the call option in the account where you hold the related stocks. The amount for which you sold the options, less commissions, is put into your account right away.

If your plan is living off covered calls, as opposed to reinvesting call option income to build wealth through capital gains, you’ll simply transfer the call income out of your brokerage account into your personal account.

Just remember to set aside money for taxes, as previously addressed. A good way to manage this is to set aside a percentage of your call option income into another account that is specifically for taxes. We keep such an account at our brokerage firm nicknamed “Taxes”.

Covered Call Income Is Inconsistent

One problem with living off covered calls is that the income will vary from month to month and year to year. If you’ve been planning on or making a standard retirement withdrawal strategy following the popular 4% rule, you may find this inconsistency challenging.

Some months may even have a loss in your overall covered call strategy if your stocks drop below their purchase price, as explained above. In general, however, a successfully implemented covered call strategy can reasonably provide about 1% to 1.5% of the value of your stock or ETF, on average, for a sideways or up trending stock or ETF.

Living Off Covered Calls in Summary

As you can see, assessing if you can live off covered calls is more complex than simply multiplying the value of your stock portfolio by 1% to 3%. I always like to point out potential investment risk here at Retire Certain so I have addressed risk a lot in this post as well as the other challenges of covered call writing which I didn’t realize when I got started.

Having clarified the challenges related to potentially living off covered calls, you can see that this conservative option strategy can make sense as a lucrative income stream for stock investors willing to put in the effort to manage both risk and income potential optimally.