Many companies regularly distribute a portion of their profits in the form of a dividend to attract investors and incentivize them to remain long-term shareholders. But most companies, ETFs, and commodities don’t pay a dividend at all. When there’s no dividend, the only opportunity for income or a profit comes from a capital gain (or loss) from selling the position.
Wouldn’t it be nice to get regular payouts from “no dividend” investments? As a dividend, these payouts could be used for income. Or, if left invested, our cost-basis could be further reduced with every payout.
A Commodity ETF Example
While the strategy presented here can work on any stock or ETF that has options, it works best with relatively lower-priced products under about $25. A commodity ETF such as SLV – currently trading around $22 a share — is an ideal candidate.
Like gold, silver has historically been used as a physical store of wealth and a hedge against inflation. But long-term charts on gold and silver show that these products often go sideways for a long time before having a significant move. Historically such investments have required buying, holding, and waiting – sometimes for a very long time.
One way to compensate for the lack of a dividend on silver is to purchase shares of SLV and write Call options against those shares. This is a relatively simple options strategy of writing “Covered Calls”.
Two Ways to Open the Trade
We want to buy low and sell high by purchasing shares on weakness and selling Calls on strength. We can also sell Puts on weakness as an alternative to purchasing shares. The Profit and Loss graph of selling a Put is the same as for selling a Covered Call.
If we sell Puts, we’ll likely have shares “Put” to us at some point and will then own the shares at the strike price we sold minus the premiums collected. Having shares put to us at a reduced cost basis is part of the plan. When we sell an Out-of-the-Money (OTM) Put, we’re methodically nudging the statistics in our favor by “buying low” when there is a pull-back in the underlying. We can alternately think of selling a Put as a Limit Order to buy shares with the limit price equal to the strike price we sold.
When shares are “Put” to us, we then sell Calls against the shares we now own. And the cost (or basis) of the shares we purchased will have been reduced by the cumulative option premium collected by selling Puts.
Trade Management
We may not have a great opportunity to sell option premium in every possible cycle. There will likely be times where the underlying will be in a pullback, and we may want to wait for the price to recover before selling Calls. Actual expiration cycle outcomes are likely to be a mix of having Calls expire worthless in some cycles and having shares called away in other cycles.
Writing Covered Calls is a relatively low-maintenance strategy that doesn’t have to be watched continuously. Once we write Calls, the shares will either be called away or not. But we do have to be patient and let time decay in the options we sold work for us.
If the Calls we sold expire worthless, we still own the shares. In this case, we sell Calls again for some future expiration cycle and collect more option premium.
If our Calls expire In-the-Money (ITM), the Calls will be exercised, and the shares will be called away. The shares are purchased by our counterparty at the strike price we sold, and we no longer own the shares. As the Call seller, we keep the premium and any gain on the shares. In this case, we start the process again by buying shares or selling Puts.
Upside and Downside Risks
Writing Covered Calls (and selling Puts) is a neutral to bullish strategy. There can be sustained downtrends, price shocks, and changes in volatility that can affect strategy performance. As with any strategy, it’s important to ask and understand “What could possibly go wrong?” before getting involved.
There’s always a tradeoff when selling Covered Calls. In exchange for collecting option premium, profit is limited to the amount of premium collected plus any appreciation in shares up to the strike price. For that reason, I tend to sell Out-of-the-Money (OTM) Calls.
Keeping probability in our favor and letting time decay work for us are benefits of selling a Covered Call (or Put). As option sellers, we don’t need large up moves to make a profit. We have the statistical odds in our favor and option time decay working for us. The underlying share price can go up, sideways, or even down a bit, and we can still profit. The “Synthetic Dividend” is one of my favorite ways to generate repeatable profits.