The tweet below from a covered calls “expert” highlights the exact dangers of using Covered Calls and Cash-Secured Puts on the wrong stock.
I’m not naming the person who wrote this in 2021 because it wouldn’t be fair, as I’ve made my share of bad picks too. However, the issue wasn’t so much the stock itself but rather the application of a long-term option selling strategy to it. It was terrible advice and illustrates a critical point about selling options: whether you’re a trader or an investor, the quality and stability of the company matters significantly to this strategy. And this has nothing to do with hindsight as you'll see.
The author described SQ as a promising company in digital payments. True then as it probably is now. It may have had strong prospects, but in 2021, it had surged by hundreds of percent to a P/E ratio of over 400. Despite rising earnings during the pandemic, its cash flow was highly erratic, and it was undeniably a high-flyer with a nosebleed valuation.
Enter the covered call strategy. The author suggested that while dividend stocks are fine, covered calls are a better path to financial independence, especially for those without enough savings to rely on traditional dividends. Option premiums on stocks can indeed exceed traditional dividends. He says that covered calls are 4 times better than dividend growth investing. Ok. Wow.
A few key points to remember:
1. This advice risked pushing people out on the risk spectrum without acknowledging (or being aware of) the dangers of doing so.
2. Yes, options can create yield on high implied volatility (high pricing) stocks that don’t otherwise provide yield. However, many no-yield stocks are more speculative and prone to volatility. Selling calls simply doesn’t transform these stocks into better companies and comparing them to dividend payers is misguided.
3. Dividend stocks offer yield while allowing investors full upside in the stock. With covered calls, you retain much of the downside but only some of the upside. The performance profile is drastically different.
You might argue that even quality stocks can get hit hard, as seen in 2022. True, but quality companies typically recover. They have better chances of stability and recovery, while speculative, cash-flow-poor companies may plummet to zero or languish as dead money for years.
For instance, SQ fell over 80% following his recommendation and has only slightly recovered, still around 70% below his recommended level and roughly the same price it was at over two years ago. In contrast, quality balance sheet, high cash-flow, wide moat and higher margin companies have generally thrived since 2021.
You might think you can sell premium on the way down to defend, but selling calls on a rapidly declining stock often still results in poor capture. You also risk losing your position below your cost basis, and the absolute yields you harvest won’t be as lucrative as before.
This is crucial and often overlooked. If SQ options yield, say, 30% a year in the at-the-money options: 30% on $70 is much less than 30% on $233, assuming implied volatility remains similar. Your income drops to a third of what it was and you principal has been decimated. How’s that retirement plan going?
This underscores a significant issue with covered calls, and the crux of the takeaway today: you’re creating a bond proxy on a product that has full principal risk. Unlike a bond, which guarantees your principal at maturity, a covered call on a stock has no such guarantee. Your principal can drop to near zero in theory. This strategy is not to be looked at as a kind of secure bond, as I fear so many do. But it can be approximated to a bond-like approach if certain strict conditions are met.
We must strive to ensure our principal is preserved long-term. But that means prioritizing quality is paramount. Quality companies should endure and bounce back, though we can never be 100% certain. There is however a great deal of evidence that higher profit and high free cash flow companies outperform over time by a fairly significant margin. For example high free-cash flow companies tend to outperform the rest by around 18% per year. High gross margin companies tend to outperform by 3-4%. Selling puts in quality names has outperformed by a wide margin.
Will you get less premium for those names? Probably. But are you in the business of trading for excitement or are you in the business of actually retaining premium and making money over time. You decide.
The dangers of following ill-informed advice, especially on social media, are very real. Make sure you’re following the right people. People with almost 30 years of having done this professionally, managing a $billion in options strategies and having generated $750 million in options cash flow for investors. That's me. And the best part? You can learn to do this...
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