Does Living Off Covered Calls Really Work?

Are you wondering if living off covered calls is feasible? 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 little known but sensible income stream.

Is Living Off Covered Calls Possible?

There are seven main factors in determining if living off covered calls is an option for you. (I couldn’t resist the pun.) I’ll write about each of these factors in more detail below. Several of these factors are rarely mentioned by most covered call gurus, yet they are crucial to keeping your income streams flowing smoothly.

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

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

Covered call income will vary based on several factors, but 1% a month is a conservative estimate for the amount of income you can generate. This is income that you’ll collect in your brokerage account for selling call options against your stock holdings.

In this case, if $5,000 a month covers your expenses, living off covered calls could work for you, especially when it’s one of several income streams.

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

The idea with living off covered calls is to live off income from investments, instead of withdrawing investment capital.

This one percent a month income equates to about 12 percent a year. This compares very well to typical dividend income from the S&P 500 index of around 1.75 to 2% a year.

But wait, there’s a lot more to consider before you retire with a plan of living off covered calls.

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.

Look at your expenses. Make sure they are in alignment with your overall wealth plan.

Also, ask yourself if you want to start living off investments now, or if the temptation is to live a higher cost lifestyle. Would you be better off continuing to accumulate wealth, or have you made a conscious decision for living off covered calls or other investment income?

Here’s a link to my eBook on our favorite income streams for early retirement.

Is the Stock Market Headed Up or Down?

This is probably the most important (and little mentioned!) reality about covered calls that I’ll share with you here. Covered calls are a bull market strategy. This is so important I want to repeat it: Covered calls are a bull market strategy.

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.

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 your cost
3. If the stock has dropped in value, you risk your stock getting called at a loss
Are there ways to work around this dilemma? Sure, you can:
1. Buy a protective put
2. Sell short indexes during bear stock markets
3. Create diversified income streams
4. Keep aside capital specifically for covered calls after bear markets when stocks are cheaper

These strategies can work well if you are willing to put in the effort to learn and implement one or more of these solutions.

The main point is for you to understand that if you’re planning on living off covered calls, 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 will occur. In fact, we could be in a bear market at the time you are reading this article.

If that’s the case, focus on the opportunities that come near the end and after the bear market occurs.

Are You Willing to Sell Short During Bear Markets?

What’s this all about, you ask. 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 stocks in the popular indexes. This can seem complex, but, basically, you buy the index which sells the stocks in the short index strategy. When you sell a security that you don’t own, you are selling short.

This can work well with a few caveats.
1. You must be pretty good at recognizing market cycles
2. You must accept that you may get whipped around a bit as the cycles change
3. You must be unemotional about investing

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. This can be hard to put out of your brain unless you’re a very sophisticated investor. It’s just not worth the risk for many people to buy indexes that are short the market.

Managing Covered Calls

Dividend income from stocks is passive. Covered calls are not as passive. Having made that clear, a few years ago, I managed my covered call account while on a family vacation in Italy pretty easily.

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 bull market once you learn the strategy.

The reality is that not all the options you sell are exercised.

The good news 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, usually longer than you had planned. There are several steps you can take then.

Usually, you’ll sell another call. I always evaluate the stock chart before doing this. There are some sideways stocks I own that are long term holdings, and I just 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.

Or you may decide to sell the stock without writing another call immediately. All of this will depend on your covered call strategy and goals. This is what I mean when I say that covered call strategies must to be managed.

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

Also, there is accounting that must be done to track the results of your covered call strategy. You can download trades off most brokerage platform to make this easier, unless you’re a nerd like me and can’t resist creating your own spreadsheets.

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 results.

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.

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

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. 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 during low volatility years.

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.

But let’s question this risk perception. 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.

And 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 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 got sorted out. (Scroll down to watch a video on this.)

Yet the stock market moved up after March 9. And 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.

Covered calls would only have worked, however, if she had capital put aside to purchase cheap stocks after the bear market. If you were fully invested in stocks going into the bear market which had been bought at 2007 and early 2008 prices as stocks fell, she would have not been able to buy more stocks.

Her 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.

This is why I like multiple sources of income diversified among paper assets like stocks and bonds, and 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, loves hedging and more complex trades that don’t rely on market direction to work after decades of trading professionally. I like simple strategies, so we work well together. Covered calls generate simple, mostly passive income.

What is the volatility as you read this? 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.

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 compounding wealth, you’ll simply transfer the call income out of your brokerage account into your personal account.

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.

Also, remember that you’ll may need to pay taxes on covered call writing income unless it’s done in 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 many stock investors. This is especially true when you own stocks, anyway!

Wealth Building StrategiesCovered calls are one type of income stream. In my eBook I cover our favorite 9 strategies for income streams and wealth building, too. Click here to get it now. 




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

Disclaimer: This article is for educational purposes only and not to be taken as financial advice.

Thanks to my Sources:

2 thoughts on “Does Living Off Covered Calls Really Work?”

  1. The assumption of generating 1% in covered call premium per month is based on selling calls on what underlying, at what IV, at what delta?

    1. For basic covered call strategies you really don’t need to get into IV and Delta. 1% is a realistic expectation, especially during times of low volatility. It’s on the low side but I like to estimate conservative returns.

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