Blog 10 - Income Hidden in Plain Sight

Jay Mason
Jan 5, 2024
7 min read

"What makes the desert beautiful is that somewhere, it hides a well."— Antoine de Saint-Exupéry, Author and Aviator

While most investors are pleased to generate some growth and earn 1-2% in dividends, they may remain unaware of the additional 2-4% of annual low-risk, low-effort revenues to be generated from those same core stocks. Investors may buy and nurture a portfolio of stocks without ever realizing this opportunity sitting in plain sight. Imagine owning a home with a tenant in the basement suite that never pays rent. Each stock with an options string is another "room in your house" capable of generating additional rental income called a Covered Call (CC). This will:

Generate surplus revenues from core stocks, independent of dividends
Partially diminish portfolio volatility due to the contrarian nature of writing call options.

Note: This blog assumes investor familiarity with options contracts or willingness to learn. The Options Clearing Corporation (OCC)¹ provides video explanations for deploying CCs.

'Sell High, Buy Low'—Reversed

The concept for core stocks is to buy low and sell higher, then rinse and repeat via rebalancing. Selling Call options contracts on those same core stocks reverses this adage: 'Sell high. Buy lower.'

When you sell a Call contract, it represents the right for another investor to purchase your shares at a set price (Strike Price) by a future date in exchange for a premium. The buyer is bullishly speculating the underlying share price will rise sufficiently to trigger a transaction. Contrastingly, the seller (you) hopes the contract will mature unexercised, allowing retention of both the premium and the underlying shares. Selling options contracts is therefore considered "passive" income.

Odds in the Seller's Favor

According to the CBOE, on average only 10% of options contracts are ever exercised and another 30-35% regularly expire out-of-the-money worthless. Therefore, selling option contracts is a process already skewed in the seller's favor. With a little planning, the odds can be further improved.

Possible Outcomes

At maturity:

if the share price remains below the Strike Price², the seller (you) keeps the premium and the shares. By selling out-of-the-money Call contracts, you leave room for further capital appreciation on the underlying shares. However,
if the share price rises above the Strike Price, the shares would be sold from your portfolio at the Strike Price. You still keep the original premium plus cash proceeds from the sale of your shares at this higher price. You can then start over by buying new shares and writing new CCs.

The Importance of 'Deltas'

To pick a Strike Price with a high probability of staying out of exercise range, find the Greek "Delta"³ associated with each Strike Price. This is usually listed conveniently next to individual Strike Prices in the options string. An Option's Delta will range from -1.0 to +1.0 and reflects the degree of sensitivity for a change in the Strike Price to any change in the underlying share price. For example, for a Strike Price with a Delta of +0.20, when the underlying share price rises by $1, the Strike Price is likely to rise by approximately $0.20.

Alternatively, Delta approximates the probability that a Strike Price will be exercised at maturity (e.g., a Delta of +0.20 suggests a 20% chance of being exercised).

For growth stocks, we will only deploy options contracts with positive Delta's. Focus on selling monthly OTM Call contracts with a Strike Price at a Delta less than 0.20. This implies only a modest chance (20% or less) of being exercised. This range generates an acceptable premium but is generally sufficiently outside the range of an advancing stock for the short duration chosen (usually 2-8 weeks).

Covered Call Example: MSFT

Figure 1 is the June 19, 2020 Options string for Microsoft as reviewed on May 8, 2020. There were 42 days left until the June 2020 contracts expired. The current price of MSFT was $184.50.

Figure 1: MSFT Options String

Note: Call contracts are located on the left-hand side of the "Strike" column. Highlighted in the Delta column are three choices from 0.265 down to 0.058.

Figure 2 presents three out-of-the-money Strike Price choices with their respective premiums and their respective Deltas equalling the percentage buffer from possible exercise.

Figure 2: Call Contract Choices

Example:

By selling one contract maturing June 19, 2020, at a Strike Price of $200, an investor would receive a premium of $131.00 (= $1.31 × 100). This reflects an 8.40% buffer before the Call might be exercised. At a Delta of 0.167, there's a 16.7% chance of MSFT shares rising by 8.4% within the next 42 days. This low probability represents good odds to a seller while providing a reasonable premium.

Note: Each option contract equals 100 shares. Only sell a CC contract if you own at least 100 shares of a targeted stock.

Winning by Winning: Three Cushions

Three buffers to improve a seller's odds of keeping both premiums and underlying shares:

I. Advantage by Trend (When to Deploy)

Periodically, growth stock prices get ahead of themselves. After advancing three steps, they often pull back 1-2 steps before marching on. When a core stock advances—especially after favorable news (surprise quarterly results, positive earnings projections, or M&A activity)—a share's price will often surge, then plateau. This is when it becomes a prime CC candidate.

II. Advantage by Time (Duration)

Sell only short-term contracts (1 week to 2 months). Short contracts reduce the time available for a stock to advance towards the Strike Price.

III. Advantage by Price

The chosen Strike Price should be set adequately higher than the current price of the underlying core stock. These are called OTM (Out-of-The-Money) Call contracts and provide extra room for shares to rise further before being triggered.

CC Benefits

When selling OTM CC contracts, the three buffers (Trend, Duration, Price) together significantly reduce the risk of exercise at maturity. The process of repeatedly selling monthly or bi-monthly contracts is like generating 12 extra dividends per stock per year (if done monthly).

Why bother repeating monthly when you could sell one annual contract? Although monthly contracts are time-consuming, short-term contracts offer superior premiums relative to longer-term contracts over the same 12 months. Also, by selling shorter-term contracts, you can adjust terms more frequently to stay well out of the range of being exercised. Though, be prepared that strong stock surges may force exercise, even on short term, deep OTM contracts.

Non-Critical Risk

According to our methodology, the actual risk of selling OTM CCs is minimal—a "non-critical" risk. This is not because there's no uncertainty, but rather, even if shares were called away, the impact is relatively benign:

✓ You keep the original premium

✓ The underlying core stock will have risen further into profitability

✓ You receive cash equivalent to the higher Strike Price

✓ No margin capacity was used, so no interest to pay

However, when the underlying share price rises above the Strike Price prior to maturity, only the contract buyer participates in price appreciation above the Strike Price. This is an opportunity cost for the seller. While Call contracts would return negative value, the underlying shares owned would still be rising by an equal amount. Once the underlying shares rise above the Strike Price, the position becomes neutralized.

When the Strike Price Has Been Reached, Two Choices:

Buy back the Call contracts and accept the loss
Allow the contracts to be exercised—shares are sold from the portfolio and receive the cash proceeds (number of contracts × Strike Price)

Share Replacement Choices

When a contract is exercised, to reinstate the underlying shares, here are three recourses:

i. Re-purchase the same underlying shares using a limit order on the open market.

ii. Sell short-term OTM Put contracts (1-week to 1-month) at the previous Strike Price. This would be successful if the underlying share price fell back below this OTM Strike Price at the new maturity date. If contracts were not exercised, you still keep the premiums and could keep selling short-term Put contracts until the position were to be reinstated.

iii. Sell short-term deep ITM Put contracts (1-week to 1-month) at higher prices than the current share price (to generate a higher premium). This tactic offers a higher probability of being exercised and therefore reinstating the lost shares. The premiums paid help offset some of the missed gains above the previous Strike Price.

Rewards Worth the Risks

Overall, the potential benefits of selling Covered Calls far outweigh the risks. The real skill is setting Strike Prices low enough to garner a decent premium but high enough to stay beyond a stock's advancing growth trend. This takes experience.

Summary

✓ Deploying CCs is a low-risk, contrarian, but discretionary activity. Experimentation will help find your comfort zone when setting CC contract terms.

✓ CC contracts are contrarian in nature and partially offset the impact of market sell-offs.

✓ CCs help to build a cash reserve which also helps moderate overall portfolio volatility.

✓ The risk is low because underlying shares are already owned in the core portfolio and the probability of exercise is reduced depending on the degree of buffers chosen.

✓ While 30-35% of options contracts expire worthless (on average), the probability of success can be further improved by:

Selling CCs on core stocks with recent price uptrends (near 52-week highs)
Choosing higher OTM Strike Prices to stay ahead of the underlying share's pace of growth
Choosing 1- to 2-month contracts to minimize maintenance and maximize premiums
Sell contracts on green days (nets higher premiums)

✓ Selling CCs does not affect margin capacity, nor should it impact your risk tolerance.

✓ CCs can be sold in any account with optionable shares (registered or non-registered).

✓ Writing CCs is off-loading risk to speculators.

"There is surely nothing quite so useless as doing with great efficiency what should not be done at all."— Peter Drucker, Management Consultant and Author

Translation: The investment community wastes too much time trying to make perfect decisions. Spend less time analyzing and worrying. Common sense underlies most of our best decisions.

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Resources:

The Investing Oasis - Chapter 18: Covered Call Tactics

Footnotes:

Options Clearing Corporation (OCC) video resources ↩
Strike Price: The predetermined price at which the contract can be exercised ↩
Delta: One of the "Greeks" used in options pricing to measure sensitivity to changes in the underlying asset price ↩

Jay T. Mason, CFA, CFP manages the Oasis Growth Fund and is the author of

“The INVESTING OASIS: Contrarian Treasures in the Capital Markets Desert”,

as well as the blog series: ‘More Buck for Your Bang’.