A Retiree-Friendly Income Strategy
01/16/2013 8:30 am EST
At 2% or 3% a year, bonds are not the best choice right now, says Mike Scanlin, who explains how covered calls can provide the income stream retirees are looking for.
Covered calls are certainly one strategy to generate income off of your portfolio, but how do covered calls compare to say bonds and other ways to get a yield? My guest today is Mike Scanlin to talk about that. So Mike, you've got a couple of different choices here when you're trying to generate income from a portfolio. Covered calls one, maybe bonds buying bonds is another. How do you balance those two?
Well, bonds are totally safe. There's no equity risk if you buy, but they don't pay very well. Ten-year Treasuries right now are 1.5%, 1.6%, it's really hard to live on a retirement portfolio generating 2% or 3% a year.
If you were to buy large-cap dividend-paying blue-chip stocks and write covered calls against them, you'd probably get a 3% a year dividend yield, which already exceeds the bond yield. If you write in-the-money calls you can write, get some time premium on top of the dividends, you might get 6% or 10% a year out of the combination of the dividend plus the call premium.
You are taking some equity risk because you are long stocks, but on the bond side, with all the money we're printing, inflation's going to come and those bonds are going to get creamed at that time unless you hold them to maturity. So you trade off equity risk for inflation risk, but you get a higher yield while you wait.
If income is the most important thing to me, should I be going out and finding dividend stocks that are going to also, in addition to that I can write covered calls against it, pay me a high dividend?
Yeah, that's a great strategy and a lot of people do that. The risk is early exercise. The person who buys the option on the other side of the covered call trade may take exercise the day before the next dividend date so they receive the dividend instead of you.
It's not really in their interest if there's any time premium remaining in that call to exercise, it's because they forfeit that time premium by doing the early exercise. So if you don't want your stock called away and the ex-dividend date is very near the expiration date, you probably want to roll that position to something that has a decent amount of time premium in it.
What's a good expectation of a profit that I'm going to make from covered calls, whether it be monthly or annually?
I tell people a good floor is 1% a month, so 12% a year. You don't have to take much risk by doing that. If you pick higher-beta stocks or if you use any margin, a lot of people target 2% a month. That's 24% a year. You're probably not going to get that every month for 60 months in a row, but if you get it two out of three months you're doing pretty well.
So if I've got a portfolio and I want to hold the stocks long term and I only benefit from the upside, why wouldn't everybody or shouldn't everybody be absolutely writing covered calls against everything in their portfolio? What's the downside to that?
You're right. The downside is you put a cap on your upside, so you won't make as much as you could have if you are in a momentum stock or a growth stock or just something that ends up doing really well during the life of the option.
Some people say, "I don't want my stock to be capped. If it's a $10 stock and it goes to $50, I want to have a 5x return. I don't want to be capped out at $15 or whatever it is."
So the downside is putting a limit on your upside for the underlying movement. On the other hand, the call premium does protect your downside. If the stock were to go down, you will lose less by having written that call against it than if you're just straight long.