A Retiree-Friendly Income Strategy
01/08/2013 11:30 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 other things, and how do covered called compared to say bonds and other ways to get a yield. My guest today is Mike Scanlon to talk about that. So Mike you 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. So the 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, and 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 you know 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 you know 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, I can write covered calls against 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.
Alright what's a good expectation of a profit that I'm going to make from covered calls whether it be monthly or annually?
So, 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 so 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.
Alright 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. Is there any, 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. So some people say, you know 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 then if you're just straight long.