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 yields from both stock dividends and bond interest are so low, leading investors 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 wrote my first covered call, and I’ve written 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.


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’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 smoothly.

The factors 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

Covered call income will vary based on several factors, particularly the amount of capital, the strategy used, and the frequency with which calls 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 a stock’s movement and volatility. This means that for a $500,000 stock portfolio, covered call income estimates 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, especially when covered calls are one of several income streams. Here’s the simple math.

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

You’ll quickly see the advantage of selling covered calls by comparing this one percent a month estimated covered call income of about 12 percent a year to typical dividend income from the S&P 500 index of 1.75 to 2% a year.

This is income that you’ll collect in your brokerage account for selling call options against your stock holdings, which is the essence of covered call writing.

Dividends would increase the income from a covered call strategy if dividend paying stocks or ETF’s were selected. On the other hand, income taxes would offset the income.

Note that the idea with living off covered calls is to live off income from investments, instead of withdrawing investment capital; this aligns with the core philosophy here at Retire Certain. 

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


Expenses You Need to Cover from Living Off Covered Calls

It’s easy to get excited about higher return investing strategies and overlook the obvious; I understand this as much as anyone, as a nerd that does get excited about investment strategies.

The focus of this post if to see, however, if living off covered calls is feasible. This means that lifestyle expenses will determine this 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 wealth plan.


Do Covered Calls Work in Bear Markets?

Market direction is probably the most important (and little mentioned!) income disruptor while living 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 need to 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

Are there ways to work around this covered call bear market dilemma? Sure, you can:

  1. Buy protective puts
  2. Sell indexes that short the market during bear stock markets
  3. Create diversified income streams
  4. Sell call options on a more actively traded defensive tactical portfolio
  5. Raise capital as stocks become more overvalued in bull markets

Now, however, things are getting more complicated. 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.

If you’re planning on living off covered calls, however, and a bear market occurs, your source of income has been very threatened.

For this reason, I like diversified income streams that work during different economic and stock market cycles. Bear markets are going to occur. It’s not “if” a bear market will happen; it’s “when” a bear market occurs.

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, the less popular covered calls are. Covered calls, however, remain primarily a bull market strategy.

Fortunately, stock markets go up 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.

Selling Short During Bear Markets

You probably already know that the S&P 500 index is based on buying the 500 companies in that index.

There are also ETF’s 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 short 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 caveats.
1. It’s impossible to know the exact timing for 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, it increases in value.

Based on all of this, in my opinion, it’s just not worth the risk for investors to buy indexes that are short the market. This means investors wanting to live off covered calls will need to find other solutions for lack on covered call income during bear markets.

Managing Covered Calls

Dividend income from stocks is passive. Covered call strategies are not as passive. Having clarified this, I’ll write that a few years ago, I managed my covered call account while on a family vacation in Italy with little effort of interference.

Ideally, you’ll buy a stock, sell the call option, 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 sideways or bull market once you learn the strategy.

The reality is that not all the options you sell get exercised by the option buyer.

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 be exercised. This significantly tilts the probability in your favor when you’re selling covered calls which 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 possible 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 call isn’t exercised. The primary reason I own the stock or ETF also affects the actions I take. 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 writing 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 stocks and sell a call when the stock is around the price I paid. This adds a little income here and there. It works especially well with dividend income stocks you are happy to own anyway.

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

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

Accept that management of stocks that don’t get called is a part 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.


The Volatility Index for the Stock Market

While this may seem counter intuitive, living off covered calls is more lucrative during times of high uncertainty. This is due to the Volatility Index.

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 the higher quality underlying stocks, for example. Volatility decreased, however, into the extended bull market. Near the money covered call premiums of 1% to 2% are more the norm for high quality stocks, however, 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.

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 of 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 crisis.)  

An investor could have made some very good covered call income based on a basic awareness 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 9, 2009, however. 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.

Capital for Covered Call Stocks

Covered calls would only have worked during the bull market, however, if capital had been insightfully put aside to purchase cheap stocks after the bear market. If you were living off covered calls prior to the bear market, at least some capital would have 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, an investor 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. 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

This is 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 things 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 maintains 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. I like simple strategies, so we work well together. Covered calls generate simple, mostly passive income.


How Volatile Is the Stock Market Today?

What is the volatility as you read this post? You can easily check it out. The index that measures stock market volatility is known as the VIX. VIX is also the symbol that represents the Volatility index if you want to track it.

You can see how the volatility moved over the decades on the chart below. Look how the volatility was higher during the first 2000’s decade when there were two nasty bear markets. This Convoy Investments data was pulled by Market Watch early 2018, so the 2010’s full decade will probably be even lower. Volatility picked up, however, later in the decade as well as 2020.

implied volatility effect on living off covered calls

The Logistics of Living Off Covered Calls

One of the nice aspects of covered call selling is that getting paid is simple. In fact, 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 building wealth from capital gains, you’ll simply transfer the call income out of your brokerage account into your personal account.

Covered Call Income Is Inconsistent

One problem with living off covered calls is that the income will vary from month to month. If you’ve been planning on a standard retirement withdrawal strategy, such as the popular 3% or 4% rule, you may find this inconsistency challenging.

Some months may even have a loss in your overall covered call strategy, 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 fund, on average.

Covered Calls in an IRA

Also, remember that you may need to pay taxes on covered call writing income unless it’s done inside your IRA. As of this writing, this conservative stock option strategy is allowed in IRA’s.

If you will need to pay taxes on your call income, 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.


Living Off Covered Calls in Summary

As you can see, living off covered calls is more complex than simply multiplying the value of your stock portfolio by 1% to 3%. Having clarified the challenges related to living off covered calls alone, you can see that this conservative option strategy can make sense as a lucrative income stream for stock investors much of the time.



Watch This Video Below on “Selling Covered Calls for Passive Income”

Thanks to my Sources:

The information on this website is for education only and is not to be construed as personal financial advice.