How To “Write” Covered Calls For Safe 8% Yields

| February 24, 2017 | 0 Comments

optionsMost investors buy stocks and hope they’ll go up in price. They do nothing in the interim to generate cash flow from those stocks while they sit in their portfolio – like writing covered calls.

“Write” what?

I’ll explain. And I’ll also highlight some popular exchange-traded funds (ETFs) and closed-end funds (CEFs) that will help you generate 8% yields or better from this income strategy without actually handling an options contract yourself.

A call option is a contract that gives its buyer the right to purchase a stock from the seller for a certain price within a certain period of time. For that right, the buyer pays the seller a sum upfront, called a premium.

Option traders buy calls hoping they can multiply their money in a short period of time. Rather than buy a stock and hope for a 10% gain in a year or so, they buy call options aiming for a 100% gain in a month.

Of course there’s a catch – otherwise option traders would be the richest people in the world! And the caveat is time. When you buy a call option, not only do you need the share price to move higher for you to make money – but you also need it to happen within a relatively short timeframe.

With each day that passes, options decay in value. That’s bad for buyers, but great for sellers – those who collected the premium up front. With each passing day, they grow richer. They don’t have to worry about the clock. In fact, it’s their friend.

Recon Capital’s NASDAQ 100 Covered Call ETF (QYLD) takes money from option buyers. It buys the NASDAQ index, and writes calls just above the current price that expire in about a month.

For a 0.60% management fee, you can outsource your option selling to QYLD. The fund pays a net 8.6% annual yield than thanks to the premiums it sells to option buyers, and the capital appreciation it enjoys from the index itself.

This sounds like a good strategy – and it is – but there are a couple of big flaws in QYLD’s execution:

  1. It’d reap larger premiums by selling covered calls on individual stocks rather than the index itself, and
  2. It should be selling options with even shorter expiration times to maximize the value that expires with each passing day.

Over time, these miscues add up. Since inception, QYLD has been less volatile than the NASDAQ (as you’d expect). But its investors are missing out on most of the index’s upside:

QYLD Gets Killed

If only there were a human at the helm!

Fortunately we can upgrade to a living, breathing money manager for a modest fee. For example, Keith Hembre runs the Nuveen NASDAQ 100 Dynamic Overwrite Fund (QQQX) and employs a strategy more nuanced than my simplified example. He actually buys the individual stocks, and sells call options against them.

Keith usually sells options on 35% to 75% of the portfolio. He ups the percentage when Nuveen’s indicators look bearish (to protect on the downside) and holds more “uncovered” positions when tech looks bullish (to maximize upside).

In exchange for his expertise, our management fee is 0.93%. That’s money well spent – Keith has earned his paycheck, with his hedged gains keeping pace with the unhedged gains provided by the NASDAQ itself:

The Human Touch Matters When Selling Calls

QQQX pays a 7% annual yield. It sells for about its net asset value (NAV) today, but has traded for at an average 5.1% discount to NAV over the past six months.

(Steep discounts to NAV are another benefit of CEFs – basically free money – thanks to the market inefficiencies in this underappreciated corner of the income world.)

I like free money in addition to my high yields, so I prefer to purchase CEFs when their discounts are high. And I like three funds in particular as my “best buys” for 8% yields right now.

The 3 Best CEFs to Buy Today

CEFs are a cornerstone of my 8% “no withdrawal” retirement strategy, which lets retirees rely entirely on dividend income and leave their principal 100% intact.

Well that’s not exactly right. Their principal is more than 100% intact thanks to price gains like these! Which means principal is actually 110% intact after year 1, and so on.

To do this, I seek out closed-end funds that:

  • Pay 8% or better…
  • Have well funded distributions…
  • Trade at meaningful discounts to their NAV…
  • And know how to make their shareholders money.

If you’re an investor who strives to live off dividends alone, while slowly but safely increasing the value of your nest egg, these are the ideal holdings for you. Click here and I’ll explain more about my no withdrawal approach – plus I’ll share the names, tickers and buy prices of my three favorite closed-end funds for 8.2%, 9.9% and 10.1% yields.

 

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Category: Covered Call Writing

About the Author (Author Profile)

Brett Owens is the Chief Investment Strategist at Contrarian Outlook.

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