Tales of a Technician: Cash Flow Trickery | Tackle Trading
When introducing the masses to the covered call strategy we wisdom dispensers like to equate real estate and rental income to stock ownership and covered call selling. If you’ve yet to have the pleasure to hear such a tale, allow me.
In 2011 you bought a residential property for $100k. All cash, because that’s how you roll. You’ve heard for years that real estate can be a good investment. It goes up in value, hedges against inflation, and chicks dig real estate tycoons.
Fast forward to today. Five years have passed and your home value is now, drum roll please … $100k.
So you complain to me, your buddy. Our conversation goes like so:
You: Curse you real estate gods! I’ve tied up my hard earned dough for five long years and you’ve given me zippo for my troubles.
Me: Well, Tom (Dick, Harry, whatever your name is) did you rent out your house along the way?
You: Rent? What’s renting? Never heard of it. I thought the only way you made money on a house was if it went up in value.
Me: Well that’s one way but you also could have rented your house out to someone in need of a place to live. In doing so you could have brought in, I dunno, maybe $500 or $1000 a month in income. If you brought in even $500 per month you would have scored $30K over the last five years just in cash flow.
You: Wow, I’m dumb.
Me: Nope. Just ill-informed. There’s a difference. And check this out. By scoring $30K along the way you reduced your cost basis on the house to $70K. Get it?
You: Got it.
Me: Imagine if you kept renting out the house for the next 20 years. At some point you will have captured $100K in income effectively reducing your basis on the house to zero. Then if the house blows up technically you’re not out any money at all.
Now to the stock market. Suppose instead of buying a house for $100K you bought shares of the SPY in 2011. And pretend like the SPY has gone sideways for the past five years leaving you with nothing to show for your big ol’ investment.
Guess what. If you came to me complaining my response would be the same as that to the real estate investor.
You: Curse you stock gods! Five years and nothing to show for it.
Me: Well, did you rent out your stock along the way?
You: Of what do you speak?
Me: You could have been renting out your stock every month to score some income along the way.
You: No Way!
Me: Way! It’s known as selling covered calls. Let’s say you bought shares of the SPY at $100 apiece in 2011. For $100K you could have purchased 1,000 shares. And every month you could have sold ten call options allowing you to capture let’s say $1,000 per month ($100 per contract). Over five years you would have generated $60K in cash flow ($12k per year) from selling covered calls. Think about the affect that would have on your cost basis. Since you brought in basically $60 per share your basis on the stock would have dropped to $40 from the initial $100. And if you continue to generate income from covered calls for the next decade there may even come a time where you reduced your basis on the stock to zero.
So that’s the gist of the analogy. Now, here’s where things diverge. When you rent out a house you capture the rent no matter what the house value does. Plus you’re not limiting how much you can make in the house if it appreciates in value.
With covered calls it’s a bit different. First off when you sell a call option you promise to sell your stock at a set price. That limits your upside in the stock right off the bat. In that sense covered calls are more like a lease option in real estate. Basically a lease option is when you allow someone to rent your house with the option to buy at a certain price for a set time frame. If my house is $100K and I give you the right to buy it at $105K for the next year, then I’m capping my profit potential on the house at $5K.
But it doesn’t stop there. If your stock falls (USO, anyone?) you have to keep selling lower strike calls. With XYZ at $100 maybe I start out selling the 105 call. Unfortunately, if the stock drops I’ll have to sell lower strike prices each month to bring in a similar amount of premium — the 100 call, 95 call, 90 call, and so forth. Suppose after six months the stock has descended to $70 and I’m short the 75 call. Sure, I may have brought in some income along the way (say, $7) but I’m down $30 on the stock. Feel free to get all excited about that $7, but let’s be honest, your account value is still down substantially.
So what’s the proper way to think about your position here? Because of the short 75 call even if the stock were to magically recover back to $100 tomorrow I wouldn’t participate in the bulk of the upside. Tricky, tricky.
My answer… next time. Let’s let the suspense stew a bit in that big old noggin of yours.
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Originally published at https://tackletrading.com on February 22, 2016.
