Is a Buy-Write Fund Right for Your Retirement Account?

This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

Today’s topic is a bit advanced, so I’ll begin by boiling the lesson down to the key points, then elaborate for those who want to know the details.  The key things you need to know about buy-write funds are:

  1.  They can generate a good amount of cash income regardless of current interest rates (with option writing, you can basically turn any stock into a dividend-paying stock).
  2. They are more volatile than bond funds but less volatile than stock funds.
  3. They won’t go up as fast as stock funds, but also won’t go down as much.
  4. You have the potential to make on the order of 25% per year from buy-write funds, but you will rarely do this.
  5. They will perform the best of anything when markets are stagnant.

So there’s the minimal you need to know.  For those who want more explanation, please read on.

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What are call and put options?

You have probably heard the term, “stock options,” when hearing about a CEO who made a fortune because he received stock options from the company.  An option is a legal contract between two people.  This contract allows one person, the option buyer, 1) to purchase (or sell) 2) a fixed number of shares 3)at a specified price, 4) before a specified date.  An option to purchase is called a call option, where the option to sell is called a put option.  It is called an option because the purchase or sale is optional, purely at the discretion of the option buyer.  The option buyer would buy (or sell) shares from (to) the option seller, also known as the option writer.

Option writers can be covered, meaning they own the shares in the case of a call or have the cash in the case of a put, or naked, meaning they don’t.  A naked option writer hopes that the person who holds the contract never executes it, otherwise he’d need to somehow go out and buy the shares at whatever price they were trading so that he could turn around and sell them to the option buyer (in the case of a put, he’d need to find the cash to buy the shares at the specified price, regardless of where they were selling for now).  As you can imagine, being a naked option writer is insanely stupid and a great way to lose lots of money.  Really, it was naked option writers (who didn’t know they were naked because they bought offsetting options from other naked option writers) who caused the housing market crash in 2008 to almost take out several US financial firms.

To make things easy, most option contracts are standardized, meaning they all are for the same number of shares (typically 100 per contract), have regularly spaced prices at which the shares are bought or sold (called the strike price), and all expire in monthly groups on the same date (the date at which the contract expires is called the expiration date).  For example, this month all of the options expire on Friday, March 16th.


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Why would someone buy options?

Options were originally meant as little insurance policies, whether letting someone buy or sell a stock at a certain price.  They have become much more popular as speculating tools, however, since they provide something called leverage, which is when you use a little money to control a lot of money.  Most readers are probably most familiar with leverage when it comes to home buying, where you can put $10,000 down on a $500,000 house.  If the home price goes up 1o% over the next year, you could then sell it for $550,000, making $50,000, or 500% profit.  This is really good for a one-year speculation.  If you had put down the full $500,000 for the home, you would have still made $50,000, but now it would have only been a 10% profit.  Leverage magnifies potential gains.

Options do the same thing.  You might buy a set of 10 calls on a $100 stock for $500, meaning that with $500 you now control $10,000 worth of stock.  If the stock goes up $10 per share to $110, you might be able to execute the options and sell the stock, making a quick $1000, or 100% profit.  (You might also be able to just sell the options to someone else for $1000 since the price of the options would go up when the stock price went up.)  If you had bought the shares for $10,000 instead of buying options, you would have only made a 10% profit, plus you would need to find the $10,000 somewhere to buy the stock.  This is why people use options, the potential to make a fast profit without putting too much money down.  This potential return comes with great risk, however, since your options expire worthless on the expiration date if you don’t use them.  You therefore need to be right about both the direction and the timing.

What about writing options?

The person on the other side of the trade described above, the option writer, would get money from the option buyer called a premium.  The premium in the example above was the $500 the option buyer paid for the calls, which went to the option writer.  The value of the premium varies constantly, based upon the price of the stock relative to the strike price, how volatile the stock is, and how long it is until the expiration date.  Basically it is whatever the person who is writing the option is willing to accept from the person buying it at any given time.  While the option buyer has the potential to make a lot of money, most of the time he doesn’t.  Some thing like 9 out of 10 options expire worthless, meaning the option writer pockets the premium and the buyer limps away with nothing.

For this reason, while the potential profit is less, it is still better to be the option writer because the odds are so much on your side.  You might only collect $800 when you write a set of calls on $20,000 worth of stock you own, but if you can do that six times a year, that’s $4800 per year, or a 24% return.  Compare that with the historical 10-15% return you can get from buying and holding stocks, and you can see why it is attractive.  It is like being able to make any stock into a dividend-paying stock.

Writing covered calls is not without risk.  If the price of the stock drops, you will lose money, or at least need to wait for the price of the stock to recover, which could take weeks, months, or years (or never).  You are also setting a limit on your potential return.  If you have shares of XYZ stock, selling at $95 per share, and you write calls with a strike price of $100, once the stock passes $100 per share you will no longer be making any more money.  Also, because there will be some positions where the stock declines in price and times when you just can’t get a good price when writing a new option, it is unlikely that you’ll actually get 25% returns.  In actuality, I’d say that you would be more likely to make 8-12% per year, but still it is a good return , especially when dividends are like they are today, at 2% or lower.  It is putting cash into your retirement account, so you’ll have cash-flow that you can use without needing to sell stocks to raise cash.

Is there an easier way than writing calls yourself?

Yes.  There are mutual fund companies that create buy-write portfolios for you.  For example, PowerShares has an S&P 500 buy-write ETF that is like an S&P 500 fund with a call option written against the portfolio.  You won’t do as well in this fund if markets are going up as you would be by just buying an S&P 500 fund, but you’ll be doing a lot better if markets are stagnant and a little better if they are dropping.  In both cases, you’ll be making 8-12% in premiums to offset whatever the underlying index is doing.  For example, in 2017 the fund provided about 11% in cash payments.  This is not as good as the 20% percent return you would have had if you were just invested in an S&P 500 index fund, but would provide the cash needed for living expenses.

Note that the price of the buy-write fund will change, meaning that your total return will probably not be 10-12% each year even though you were receiving payments of 10-12% per year.  For example, if you receive a 10% payment but the share price drops by 8%, your total return would only be 2%.  With income investment, however, you should be focused on the cash return you are getting and not the share price.  The fund price may go up or down, but all you need it for the fund to continue providing you the income you need each year.  In many ways this is similar to a rental property, where home prices may change constantly in an active market, but unless you are trying to sell the property, all you care about is getting good tenants in and seeing a steady rent check each month that increases over time.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What to Do with a Covered Call when the Stock Goes Up

Before I ever write a covered call, I make sure that I would not mind parting with the stock at the strike price.  I usually only write them on stocks that have gone up a lot in my portfolio, that I still think have good longterm appreciation potential (meaning that the company is still doing well at their business and have room to grow), but that have gotten too pricey for their current value.

For example, I recently wrote some covered calls on BJ’s Restaurants International.  I had bought the shares at somewhere around $20, I thought the stock was expensive at $45, but then the price continued to climb to around $60.  With a PE approaching 50, it was clear that although this is a great, growing company, it will take a while for earnings to justify the high price.  Rather than wait around for earnings to grow, I decided to write some covered calls and gain an income from the stock.
As it happened, the stock did go higher, and as expiration date approached it was a couple of dollars above my strike price.  (Note, options can, but almost never are, be executed before the expiration date.  Typically, however, they are executed just before expiration, so you are usually safe to wait until at least the week of expiration before taking action.)  In this case I analyzed the stock price and decided that I would not buy the shares at that price, so why should I close the position and effectively raise my cost basis.  I decided in this case to go ahead and let the shares be sold.  I bought back part of the position a few weeks later for about $10 less per share.
If I had decided that I didn’t want to lose the shares – for example if doing so would trigger a tax bill I didn’t want to pay, or if I would probably just buy the shares back at the current price and the cost of commissions for buying back the shares exceeded the cost of trading options, I might close the option position by buying an offsetting call option.  While this might cause a loss (depending on the premiums you collected when you wrote the calls and how far above the strike price the stock is), you are generally trading cash for the stock at a higher price.  In other words, you are increasing your effective cost basis on the stock.
For example, supposed you sold Jun $50 calls on XYZ corp and the stock went to $52.  Near expiration, the price of the call would be somewhere around $2.10 – the difference between the current stock price and the strike price, plus a small premium for the remaining life of the option.  If you were to close the position by buying an offsetting Jun $50 call, you would be paying $210 per option plus broker fees.  If you sold the calls originally for $1.20, you have now increased the amount you have in the stock by $2.10 – $1.20 = $.90 per share.  Note that the stock is also higher in price, so you really didn’t lose the money (yet), but you are increasing how much you have in the stock.  You should therefore ask yourself if you would buy the stock at the current price.  If not, let the stock be called away.  If so, then cover the position.
Another thing that can be done to offset the loss is to “roll the option” to a higher strike price and a later expiration date.  In our example, let’s say that you see the August $53 call is selling for $1.50.  You could close your Jun $50 calls and write an August $53 call.  This would increase the price at which you would lose the shares, giving you another dollar of breathing room, and the $1.50 in premiums you would collect would offset the price you are paying to close out the position.  Note there is a slight risk here that your existing option could be executed before you close the position, particularly if you are very close to expiration.  In that case you could end up with a naked call rather than a covered call – a very precarious position.  It would be a good idea to verify with your broker that you have not been assigned an execution before writing the new calls.
Finally, there is another reason you might wish to close the position.  Because a written call looks like short interest in your account, a stock that has gone up far above the strike price may cause your account to go into margin.  You are then paying interest and are possibly subject to a margin call even though the increase in the stock price will offset the loss on the call directly.  If this is the case, and it is a while until expiration, the best strategy is to close the option position and sell the shares to make up the deficit rather than waiting for the option to be executed.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Write Covered Call, Part Three – A Practical Example

Having covered the mechanics of covered call writing and having gone into some of the risks, let’s look at a practical example.

I currently own some shares of BJ’s Restaurants, Incorporated.  The company sells pizza and beer.  They have a series of restaurants out west and sell gourmet pizza and microbrew beer.  I think they have great prospects for the future since they are currently making gobs of money and have a lot of room to expand.  These are key features for which to look  when selecting stocks.

The market has realized their potential, however, and bid the shares up to really high values.  The PE – price to earnings ratio – is over 50.  Many fast growing companies have PE’s in the 30’s, but the 50’s are a bit extreme.  Typically PE will eventually return to a reasonable range, either because earnings increase, or because the price declines.  Because of this, I expect the stock to either sit in the current range for a few years, waiting for earnings to catch up to the price, or the price to drop to a more reasonable level given current earnings.  In any case, the stock is vulnerable to a sharp slide should the company miss earnings, a lawsuit occurs, or some other thing happens like another terrorist attack. 

I don’t really want to sell the shares.  I’ve found that when you sell a great stock, you end up putting the cash in something else and forgetting about the original.  Even if the price falls to reasonable levels or earnings increase, you may not have cash available at the time to take advantage of the lower prices.  For this reason, I’ve written a call option position on the shares.  This will provide some income should the stock sit within a range for a long period of time, and reduce the loss somewhat should the shares fall in price.

When I was ready to write the calls, the shares were trading at about $46.50 per share, having completed a really fast runup the week before.  Looking at the option prices:, I saw that the July options have reasonable premiums for the next out-of-the-money options, those with a strike price of $50.  They were selling for about $1.60 per share.  Writing May or June options did not provide enough in the way of premiums.  The later options, like the Octobers, did not offer enough given the long time to expiration. 

If I were more bearish, I might sell the in-the-money options, the July $45s, and collect about $3.80 per share.  If I did so, the price could drop to about $42 per share before I would lose some money.  With the July 50’s, If the price drops below $45 I will lose money from the current value, but I will still make some money if the stock goes up to $50.  Even better, if the stock does not move very far up from the current position between now and July, I’ll get to keep the entire premium from the options and maybe write another set of options.  At $1.60 every three months, this is about $8.00 per year, or an effective “yield” of about 17%.

If the stock stays at current prices or decreases, I’ll just hold the options to expiration.  After that I might continue to write calls as long as the stock is above $40 per share (I think in the $30’s the stock is more reasonable, yet still expensive).  If the stock moves above $50 per share and my shares get sold, I might look at writing covered puts at $45.  In that transaction I would be obligated to buy the shares if they fell below $45 per share. 

As long as I keep the cash in the account for that purchase, it is really like getting the shares below the current price.  I could continue to write puts while the stock price is above $45 until I purchased the shares.  I might even drop the strike price for future options I write if the shares get near $45 per share and continue to lead the shares down until I finally buy them back in the $30’s.  The risk, however, is that the shares may continue to climb and I never get to buy them. 

The shares could also drop well below $45, and then I would be stuck buying them at $45.  Given that I was ready to buy them at a little below $45 anyway, it really was no more risky that putting in an order to buy the shares directly.

In the next post, a summary and some perspective on covered call writing:

This is a continuation of a series of posts on covered call writing.  The series starts here:

Your investing questions are wanted.  Please send to or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.