In the last post I described how you can earn an income by using cash covered puts to gently introduce yourself to an equity position. While it works as a fantastic strategy to graduate a security into your portfolio, and thus reduce the psychological gravity associated with suddenly entering a long position, it also is a great strategy for generating cash flow from your portfolio.
Today, I’m going to flip that strategy onto its head, and describe how you can write equity secured calls to generate additional cash flows on the sell side of a position, as well as to reduce the impact that uncertainty can have on a personal investing portfolio.
The trick to using covered calls is to use them as a transitioning step to exit a position. Rather than simply selling out of a position, you can take your profits a little bit at a time by selling a call on the position. The result is that the upside potential of the position has been negated until a certain point by the premium, while the down-side of the position is equally negated. This means that you have taken a portion of your risk off the table, but still maintain exposure to the security itself.
Suppose the position trades sideways until your option expires, the net worth of your position has increased beyond what it would have if you’d simply sold out or held on. If the position goes up, you lose out on the opportunity cost, but you gain a premium that you wouldn’t have if you’d simply sold out. If the position goes down, you’ve adjusted your cost-base downwards, allowing you a price cushion for short-term decreases, while still maintaining exposure to long-term movements.
From a psychological standpoint, the implications of such a transaction are pretty immediate. By transitioning out of positions through covered calls, you’re allowing yourself a grace period, during which you can adjust the idea of the position leaving your portfolio. However, the premium acts as a hedge against indecision in the future. Personally, once I’ve sold a call on a stock, it’s like filing the divorce papers.
I’m no longer married to the position, and I’m able to begin dissolving the relationship. As I slowly liquidate the position on paper, or using the proceeds from the continuing premiums to dilute the position out of my portfolio, I am better able to pursue other opportunities. Best of all, if I manage to extract an equivalent value of my on-paper capital gains from the sale of calls, I find myself able to look at the position again as a new holding, and that I am better able to evaluate it without feeling as though my past history with the position will interfere with my analysis.
While the combined benefits of covered calls and puts provide investors with an excellent opportunity to add some sophistication to a portfolio in a way that gives peace of mind, they also are extremely lucrative tools for you and your advisor to look into. While I won’t go into details about some of the more complicated strategies I like to use to make money with these tactics, I can say that the beauty of these kinds of portfolios is their flexibility, they are accessible to any investor that is willing to take the time to understand them.