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How to Create a Covered Call Portfolio

Value investor with a deep passion for understanding and a desire to improve results over time.

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Juicing Returns

Compartmentalizing is something I've always been attracted to, and I've gotten pretty good at it over the decades. One area where I've allowed this particular brand of OCD to run its course is with portfolio allocation, particularly as it pertains to selling covered calls. If you aren't already familiar with the overall strategy, here's a piece I wrote describing the concept.

In a nutshell, this plan utilizes a rare window of opportunity, in order to generate several additional percentage points for your portfolio, but without taking on any additional risk. If this sounds impossible, you need to take a few moments to wrap your mind around what a covered call really is: an insurance policy you get paid for holding, which limits your downside even more than a classic standalone portfolio strategy for value investors. Once you understand how much they can benefit your conservative investing strategy, it's time to consider dividing your portfolio into three baskets.

Basket 1: Covered Calls (60–80%)

The first basket contains the largest share of your overall portfolio, but it's not likely to be possible (or ideal) to have 100% of your portfolio in the covered call basket. This is due to the mechanics of needing 100 shares of any stock in order to write a call, and some share prices might be a little out of your reach (at least, for the time being!).

This basket works exactly as you probably think it should: you sell a call for each stock you own, and by carefully making sure that you are always listing your strike price above your original cost, you'll not only never lose money, but you'll also be able to juice your annualized rate of return by at least a few percentage points, something that might make the difference between a successful year, and one where you lose money.

Why should you care so much about a few extra percentage points? Well, consider what happens over 30 years with a portfolio that generates a 10% return every year. Your $10,000 invested turns into more than $174,000! Not too shabby, but before you start doing a happy dance, think through what happens if you can generate an additional 5% per year: you end up with more than $660,000. The extra work to write covered calls matters, and it matters a great deal here.

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Basket 2: Prospects (10–20%)

The best way to think about this basket is as the research and development department of your portfolio. These are all stocks with options available (you can determine this by taking a look on Yahoo Finance at a specific stock), but for one of several reasons, you're not currently writing covered calls for these stocks just yet. Most likely, you don't yet have 100 shares of a stock in this category, and this can happen because:

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  • You don't know the company very well yet, so you don't want to commit to 100 shares until you understand the lay of the land a bit better, employing an "own to understand" strategy.
  • You think the company is a bit expensive right now and want to wait for a price drop, so you own a small position (say 10 or 15 shares) and are planning to buy more if the price drops.
  • The options market sucks for the stock right now. Sentiment matters a lot with options, and if a stock is going down on a given day, it's probably not a great time to sell calls since you can wait for greener pastures another day.

Having a few of these incubators in your portfolio can allow you to continue to replenish your covered call basket as your stocks gradually sell off, keeping one in the chamber at all times so you are able to continue generating income.

Basket 3: No Call Available (10–20%)

It's entirely up to you how you plan to limit your universe of stocks since there are way too many individual company names to get to know well. One way could be by eliminating anything that doesn't have options available, so you can just use buckets number one and two in your portfolio.

However, I'd suggest considering keeping a slice open for stocks you probably won't ever write calls for since there are lots of incredible values among lesser-known tickers. Some of your highest overall return opportunities may well fall into this category, so it may well have a significant place for you. There are a few key things to keep in mind:

  • You need to insist on a greater margin of safety since writing calls normally limits your downside by a few percentage points per year. Here, your downside needs to be protected with a healthy margin of safety.
  • Finding a potential catalyst can help you unlock value much sooner, and...
  • Since capital appreciation is the order of the day for these stocks (no options income and potentially no dividend), you need to find stocks with a reasonable chance of a large price increase.

All three of these bullet points are different ways of saying that you should insist on a high margin of safety for any stocks you're not able to write calls for, and you should insist on a probable return that's much higher than otherwise.

The Three-Basket Strategy

Once you've gotten the hang of writing covered calls, it is likely to become an ever-bigger part of your trading strategy. You tend to realize that limiting your downside by a few percentage points can make the key difference in you tripling, not doubling your returns over a given time horizon. Still, carving out some space for R&D (your prospects in your incubator) can allow your circle of competence to expand, and having chunks of stock on tap that you can eventually buy up to 100, then write calls for, can be extremely useful.

Finally, having a section of non-optionable stocks gives you the freedom to find the very best deals you can and to hold them for as long as you'd like, provided you can determine that the stock you want to own has a high margin of safety. Together, these three baskets can give your portfolio every chance to succeed, minimizing your downside while also letting you grow as an investor.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2021 Andrew Smith

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