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Welcome to the 27th edition of the Tech Financial Planning (TFP) newsletter.
If you have a big bunch of stock in one company, one of the hardest decisions is to deciding when to sell.
For tech professionals with larger, concentrated positions, covered calls can be a great strategy to generate some extra cash.
In this newsletter, we’ll break down what covered calls are, why you would use them, go through a rough framework, and run through an example.
TL;DR
Covered calls can be used to generate some extra income while setting a selling price
You typically can only use this when you are no longer with your company
It’s not a beginner strategy that you should jump into lightly.
A Quick Overview on Covered Calls
This will not be an in depth primer on options trading and covered calls. There are plenty of great resources out there, like this article from Investopedia and this overview from Bankrate.
Schwab has a great definition: “A covered call is when you sell someone else the right to purchase shares of a stock that you already own (hence "covered"), at a specified price (strike price), at any time on or before a specified date (expiration date).”
Still not sure what it all means?
That’s ok - this isn’t an easy or beginner strategy, but in the right circumstances, it can be a great tool.
Why use covered calls
I work with a lot of tech employees that come to me with huge chunks of their net worth all in one company.
Often it’s north of 50%, and sometimes close to 90%.
When you’ve worked for a hyper growth company that’s made you a ton of money, you become emotionally tied and invested, and it can be tough to sell out.
Even if you know you should.
In the right circumstances, I like covered calls because it allows you to generate income on a large position while setting a price that you are comfortable selling at.
In a way, it takes some of the emotion and the decision making out of your control.
While potentially making a good chunk of money.
A Framework
If you want to start writing covered calls, this is a good starting point, but by no means rules set in stone.
Amount: A starting point would be to sell calls on 20% of the position (i.e. cover $100k of the $500k) up to 50%.
For example, if you had a position of $500,000, you would “cover” $100,000, up to $250,000.
This is a conversation though: “how much are you willing to sell at higher prices (which would be the strike price).”
Strike price: Another conversation here with some nuance:
At what price are you okay selling shares?
What are the implied yields of that strike (aka how much will you make)?
For example, you could write calls with 90% price buffer (i.e. the stock has to go up 90% to hit the strike price) but your yield/price of the option is going to be next to nothing.
Put simply, you aren’t going to make much money because it’s extremely unlikely for the stock to go up 90% in a short time frame.
It’s a balancing act between finding a yield that pays you a decent income and finding a strike price that you are ok selling at.
Timeframe: The longer the timeframe, the higher price you can sell an option for, improving income.
For example – a 1 month contract for a stock w/ 100$ strike sells for significantly less than a 3 month $100 strike.
Which makes sense - there’s more time for the stock to hit that price in 3 months than in 1 month.
So again, there’s a balancing act here: You can sell higher strikes (lowers option price) at longer dates (increases option price) to make up yield.
Ultimately, a solid starting baseline is 20% position coverage, about 20% out of the money or where you can find yield on a strike, with rolling 1 month and 2 month contracts (timeframe).
Let’s look at an example
Let’s say you have a Procore position of about 30,000 shares.
As of writing on 3/10/2023, Procore stock is trading for $58.23.
Your position would be worth $1,746,900.
Let’s say you were comfortable selling a decent chunk (say 10,000 shares) of your position if the stock were to hit $80 a share.
We would look at April 21 contracts for $80 and let’s say we could get a premium of $1.20 / share.
This means for writing a covered call on 10,000 shares, you would generate income of $12,000.
$12,000 premium = $1.20 / share premium x 10,000 shares.
Not bad!
If the stock doesn’t hit $80 between now and April 21, you would keep all the shares and get $12,000.
If the stock were to hit $80 or more, you would sell the 10,000 shares for $80 / share, plus get the $12,000.
So let’s say the stock rose to $85.
Your gain would be capped at $80, but you would still have a $21.77 gain per share.
Your gain alone would be $217,700, plus the $12,000 premium, for total income of $229,700.
One point to add - once the April 21 date hits, it could make sense to write another set of covered calls.
Let’s say in 2023 you wrote 6 sets of covered calls and got a premium of $12,000 each time.
That’s an extra $72,000 in 2023!
Some Key Factors to be aware of
1/ If you have a large position in a single company and you are still employed by that company, you usually can’t do any sort of options trading.
This means if you work for Procore, you can’t do covered calls on your Procore stock.
You usually can once you leave (check your stock plan - depending on your company and your role, you may have different restrictions)
2/ If the stock takes off, your profit will be limited.
In our example above, say the stock went to $100 / share by April 21.
In that case, you would have been much better off just holding the stock because remember, you are forced to sell at $80.
3/ This is only a partial hedge.
If the stock drops tremendously, your loss is only limited by the premiums you received (in our example, the $6,000)
4/ It typically makes sense for larger positions.
Think in the hundreds of thousands for starters. It’s probably more hassle than it’s worth for anything smaller.
5/ This is not a beginner's strategy.
It’s not something you should rush out and try to execute tomorrow.
It’s something you want to spend some time on and think about, and if you have an advisor, talk through.
Putting It All Together
If you have a large position that you aren’t ready to sell out of right now, covered calls can be a great way to generate some extra income.
Particularly if you do have a price you are willing to sell at.
Done correctly, this can be a great strategy, but not one that you can or should jump into blindly.
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