My goal is to create an income of $5,000 per month working from home by writing covered call options on our investments. But in order to be successful, I need to have a plan!
While I’m comfortable writing calls and have a good deal of experience, earning a significant income will require discipline and rules to keep me on track.
So I’m going to detail the strategy and rules that I’ll follow in my covered call option plan.
Portfolio Investment Balance
I’m a pretty conservative investor, and that has served me well over the years. Solid companies that pay dividends and real estate investment trusts make up the vast majority of my portfolio.
The last thing I want to do is to take on more risk than I’m comfortable with by overextending the amount of my account used for option trading. So balancing my portfolio is the first rule in my covered call option plan.
I will devote no more than 50% of my holdings to options trading, with the other half comprised of the more conservative dividend paying investments I love.
The stress of a market downturn when too much of my portfolio is in higher risk stocks will affect my trading decisions. So keeping a 50-50 balance of my holdings will help me stay focused.
Use of Assets
The portion of our portfolio that I’m going to use to start my covered call strategy will be in an IRA for 2 reasons:
- This account is large enough for me to diversify with several stocks. I’ll get more experience with the higher volatile stocks by having several calls tracked at once.
- I can only trade covered calls in this account. There’s nothing that will keep me focused on my plan more than having tight restrictions!
- This is the account where our 72t distribution is coming from. So there will be no additional funds withdrawn or added to this account until the end of the 5 year period. Covered calls and dividends are the only way to produce income.
When I feel that I’ve gotten my plan refined over the next few months, I will then start to write calls in a smaller brokerage account. This is the account where we will begin taking an income based upon the plan guidelines.
Stock Purchases
The only stocks that I’ll purchase for my covered call writing will be stocks that I wouldn’t mind holding long term. Why would I want stocks to hold long term when my intention is to write short term calls?
Because at any given moment, a stock, or the stock market in general, could fall significantly. When that happens (not if), I don’t want to be stuck holding a stock that I have no confidence in.
Any stock can drop significantly at any time, whether it’s from missing earnings expectations, profit taking, or eroding fundamentals, just to name a few reasons. An economic downturn can bring a bear market where all stocks normally go down.
So if the holdings that I’m using to write covered calls take a 30% haircut, do I want to continue selling calls that could be exercised at well below my cost? Of course not.
I will want to be holding stocks that I feel will rebound and do well over time, not have a basket of low quality companies just because they had high option premiums.
So if I wouldn’t buy the stock based upon it’s fundamentals, I won’t buy it to sell covered calls!
Option Cycles
Option contracts expire weekly or monthly. For my plan I’m going to write call options monthly for a couple of reasons.
First, monthly options are more common and usually have much higher volume. Greater volume means getting in and out of my options easier and with less slippage in price.
Second, even though you can make more money with weekly options, I don’t believe it’s enough to compensate for the extra commissions, fees, and time spent keeping track of them.
Monthly options give me the right balance between premium, commission cost, and time spent.
Target Premium And Strike Price
Stocks with higher volatility will have higher premiums. I want to target a premium rate of at least 5% of the value of the underlying stock.
There is a good selection of quality stocks that generate premiums in my target range. I won’t use volatility indexes or charts, just an evaluation of whether the stock fundamentals meet my expectations and the premium is adequate for the strike price.
I’m also going to be targeting a premium based on the shortest time possible fairly close to the current price of the stock. Not only will I get higher premiums, but I don’t want to keep my money tied up longer than a month with higher volatility stocks.
Since income generation is the main goal of this portfolio, I’ll try to capture a little price appreciation if it makes sense. But I won’t be writing calls that lose premium in order to gain profit from a higher strike price.
This will also help reduce risk in a market downturn since the potential upside gain may never materialize. The higher premium will reduce my cost basis more, which will help when I’m trying to bring the trade back to even after a price drop.
Accepting Profit Limitations And Downside
During all of my investing years, the goal was always to buy low and sell high! Income production was always dividend generation and very conservative covered call trading, being careful not to have great stocks called away.
But for this plan to work, I have to shift my focus from long term price growth to short term profits. That means my covered call strategy will have defined limits, and I won’t be able to capitalize on big price jumps.
So I could write a covered call on a stock I bought for $126 with a $130 strike price, and it could jump to $160 a week later with my option being exercised. In my conservative portfolio, that would not be an acceptable investment for me.
But I’ll need to focus on the fact the underlying stock was bought for the one and only reason of creating a specific amount of potential income. After it’s called away, I can then reevaluate the price and fundamentals to see if it’s a good candidate to buy again and write another call.
Downside risk is also a factor that is always present in any type of trading. But it’s easier to see a stock price drop in a retirement account when you’re planning to hold onto it for years.
It will be a bigger challenge for me to see stocks significantly drop when my timeline is monthly. So my focus will have to be on keeping track of my cost basis and, again, making sure that I am buying quality stocks.
This downside is also why only 50% of my portfolio will be allocated to covered call writing. The rest of my portfolio will stay with conservative, dividend-paying, low volatility stocks that should weather well over time.
Staying On The Sidelines
I think it’s going to be hard NOT making covered call trades at times. But there are going to be circumstances where staying on the sidelines will be better.
There are those who say that selling covered calls is only for uptrending markets. There are those who say that it’s a short strategy or only appropriate for sideways markets.
I believe that the ultimate goal of your option strategy should be the main driver behind whether or not it’s right for you at any given time.
So for me, I will need to evaluate market conditions periodically to determine whether it’s wiser to trade or stay out temporarily. For example, when the market fell incredibly fast this year due to the coronavirus, I think it would’ve been wise to stay out a couple of months to see where everything landed.
Allocating Profit
Due to the risk of losses and the fact that there will be times I’ll need to stay on the sidelines and not trade, I need to ensure I’m using profits wisely!
So I’ll be allocating initial profits accordingly:
~ 25% will be set aside for taxes
~ 25% will be held in cash to offset losses and for rollover strategies during challenging months
~ 25% will be reinvested, either for covered call trading or for opportunities in my conservative portfolio
~ 25% will be taken out as income
I’m not sure at this point how much of a cash reserve is the most appropriate for my plan, but I hope to know before trading in my taxable account. So, I may take the income portion and hold it as cash if I feel that it’s prudent.
Allocating profit is going to be evolving as I get more experience trading stocks with higher volatility and learning to change my focus from a total buy and hold investor.
For example, if a stock drops significantly and I want to use a rollover strategy to try and get back to my cost basis, how much cash will I need to buy back my option position? I don’t have those answers now.
Not having enough cash could make the difference between a small loss and a very large loss. Once I feel that my cash reserve is adequate, I’ll be reevaluating my plan for allocating profit.
Luck
I’m one of those people who tend to think that I’m a shrewd investor when one of my stocks goes up, but complain about being unlucky when it goes down. I’m sure many of you can relate.
However, one great thing about getting older is that you have many more experiences to teach you the folly of your ways! I learned how fast stocks can drop over the past 25 years, especially when your stock picks just include the popular “sure things”.
I also learned just how much luck has been involved in many of my successes. Some of my best early investments were the result of just picking a handful of the stocks everybody was talking about, and a couple of them wound up being great performers.
I had no idea of the fundamentals of any of these companies or how much risk each one carried. So I can’t claim any credit for the ones that went up in price.
Now my stock picks are based upon the fundamentals of the companies and the long term viability of their products. So does that guarantee that I’ll always be a successful investor? No, it just increases the odds that my decisions are better.
I will always need to be aware of how much luck has played in my successes, and in my losses for that matter. If I make poor decisions and get lucky, I will assume my strategy is working better than it really is. With decisions that turn out poorly, I’ll need to evaluate if the choice should’ve been different or if it was an unavoidable result of market activity.
Accountability
One of the reasons I started this blog was knowing that I would be more accountable for my trading decisions. (The other is that I love blogging!)
I’ll use this plan as a reference to guide me, help me focus, and keep emotions out of my trades. It will also help me to be consistent as I’m tracking my successes and failures to see what works and what doesn’t.
The next step is to post all of my activity and results each month. I will blog at least 2 times per month to update the stocks I’m purchasing, the covered calls I write, and the resulting profit or loss from each trade.
Approximately one year from now I’ll know whether my goal to earn at least $5,000 per month working from home selling covered call options was a success. I hope you follow along to see!
