Why Covered Calls Should be Part of Your Retirement Income

In several past articles, we have been writing about retirement investing and the benefits of incorporating options trading.

As someone who has lived life out of order, I argue that we need to redefine retirement. 

First, we need to reconsider the path toward retirement. If you’re under fifty years old, chances are your life trajectory will look a lot different than your parents. You’re not going to go to school, get a job, get married, have three kids, retire, and die, in that order. (Well die will still come last, but you know what I mean.)

Not Dead Yet!

Second, investors should shift focus from total portfolio value — and the psychological marker of $1,000,000 — and focus on income instead.​               

One thing we haven’t discussed in association with this line of thinking is the power of using options alongside dividend reinvestment. 

I believe that the best gateway into trading options (at a serious level and/or for a living) is to sell covered calls. Covered calls should be used as part of a comprehensive investing plan. Particularly one focused on retirement. 

Retirement Income On Steroids

As an income investor, I’m more concerned with how much income my portfolio generates than the total value of my nest egg. It’s not that I don’t want to amass a million dollars or more, it’s just that I don’t focus on it. Ultimately, I’d rather live off of portfolio income in retirement rather than have to draw down the principal. 

If you subscribe to this strategy, you probably invest in dividend-paying stocks. As you make incremental buys and reinvest dividends, your portfolio grows. Moreover, maybe you take the dividends as cash and use this for your day to day expenses. But too many investors stop there. 

Consider an example featuring AT&T (T), one of the most popular stocks among dividend growth investors:

Let’s say that today, we own 1,000 shares of AT&T (T)​ . To keep things even, we’ll call our cost basis $29.50 for a value of $29,500. At AT&T’s present annual dividend of $2.08, which yields just over 7%, the position generates $2,080 in yearly income.

Now let’s input some numbers into a handy dividend calculator to see how the income that position throws off can grow.

Here are the assumptions we made, starting with the position detailed above:

  • Additional monthly buys of AT&T stock of $250.
  • Annual dividend growth of 2%.
  • Reinvest all dividends.
  • Do this for the next 17 years (until I’m 62).
  • AT&T’s stock price stays the same.​

               

By the beginning of the seventeenth year, our position in AT&T would have grown to 6,940 shares, valued just north of $200,000, generating an annual income of $19,673, which works out to $1,639 a month.

The math and our assumptions aren’t perfect in this example. This exercise is merely for illustration purposes. That said, it’s representative of the power of dividend growth investing. 

However, think about how much more powerful it could be if you incorporate options into the mix.​ 

You own 1,000 shares of AT&T. In year one, they’re generating $2,080 in annual income. That’s fantastic, but I would bet that a vast majority of investors are leaving money on the table by not using options to amplify their position. 

If you make a habit of writing some covered calls against at least part of your substantial position in a dividend stock, you can double dip on the income front. 

Ideally, you will trade options at least 30 days out. Selling options with expirations within a 30-day window can reset your holding period. We’ll do a deeper dive into qualified covered calls at another time.  You can sell these options systematically by choosing a delta to sell each month, or you can pick and choose based on your outlook of AT&T. Systematic trading of covered calls takes the guessing game out with set parameters of when to sell and when to roll the option. Trading based on your outlook in AT&T gives you flexibility in terms of how aggressive you want to get. You have to choose the expiration date and strike price based on how concerned you are with getting your AT&T shares called away. At SteadyDime, we prefer a systematic method utilizing a 30 delta. Still, as a long term holder of the stock, you may have an excellent gauge of how it trades.

Let’s say I want to be somewhat conservative. I could write five September 4, 2020, T $31 calls and collect, as of Monday, August 3’s close, for about .33 cents per contract. For writing five calls, I receive $165 in premium income. 

At around the same time, on August 3, AT&T pays out its $0.52 quarterly dividend payment to shareholders of record, as of July 10. On your entire 1,000 share position, you’ll receive (and hopefully reinvest) $520 in dividend income. Add the $495 worth of option premium per quarter, and you’re at $1015(dividends + option premium). If you run this strategy throughout the year, you would generate $4,060 per year. That turns into a 13.76% yield. If you’re living on an income portfolio in retirement, this is a pretty incredible stream of income. Maybe you’re asking what about the options I have to buy back for a loss? Well, if that is the case, then that means AT&T has gone up in value. When you purchase those options back and roll out to another month, you can now use those option losses to offset gains for tax purposes.

Where I’m from generating a 13.76% yield isn’t anything to sneeze at. However, if that doesn’t seem impressive to you, remember we only overwrote 50% of our position. Now imagine doing this on your entire stock portfolio.

I can’t stress it enough. If you’re looking to trade options at even the most basic level, take baby steps into the ocean. There’s not a better baby step into the options world than one that pays dividends — literally. Your portfolio will thank you for writing covered calls alongside dividend reinvestment. And you’ll thank SteadyDime for encouraging you to find ways to incorporate basic options strategies into your overall investment plan. It’s a process that will ultimately make you a better trader. 

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