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Covered Call Strategy Disadvantages

A covered call is a simple strategy that involves both stock and options. First, you must own a stock or other security such as an ETF. Then you sell calls against that stock. The sold calls are "covered" because you own the stock. If you just sold calls without owning stock, they would be "naked", and that is a completely different strategy.

For covered call strategy information, see the Covered Call strategy in the Strategies page. This discussion is mostly about the pitfalls you can encounter when trading covered calls.

Covered Call Option Graph

For many stock investors, the covered call option strategy is their first introduction to options. They may hear that they can generate an income from their stock holdings that approaches or exceeds their income from dividends, and get that income monthly instead of quarterly. They may also think the strategy has low risk, because their broker allows most anybody to trade covered calls after filling out a simple form. They may not even see any risk, because their thinking is that they are a long-term stock investor, and will hold their stock through thick and thin, so why not make some extra money from the stock while they hold it?

"Covered call" refers to selling calls against any stock position. You may have owned the stock for 5 minutes or 5 years. The same strategy done all at once, in one trade, is called a "buy-write". With a buy-write you are buying stock and selling calls (writing) against the stock at the same time. You usually get a commission discount for doing the trade as a package, instead of two separate transactions. Plus you can specify a limit price for the whole trade, such as "$49.55 debit".

Selling calls means you are selling the right to buy your stock, at a certain price, by a certain date. For instance, you bought 100 shares of some stock at 30 as a long term investment. But, if it happened to go to 35 next month, you think that would be a reasonable gain and wouldn't mind selling at that price. So you sell a 35 strike call expiring next month. You make a premium for selling the call, which is yours to keep no matter what happens, as long as you don't trade out of it. If the stock is not over 35 at the next expiration, you keep the premium and the stock. If the stock is over 35, you sell the stock at 35 (you are "called out"), and you keep the premium as well. Many stock investors look at this scenario and think "how can I lose?".

A stock investor that does not use a stop loss on his stock position, and/or thinks an "unrealized" loss is not a real loss, is the loser. What if the stock in the above scenario drops to 25 next month? You get to keep the premium, but now you have a loss on the stock. What if a real bear market has just started, and in a few months your stock is at $10? What if you have an emergency and need to sell the stock at $10? Then you will find out that unrealized losses are real losses.

A stock investor that underestimates his stock is also the loser. What if the stock has some great news and jumps to $45 next month? You may have had one of the biggest gainers of your investing career, but the sold call limits your gain to just $5. You agreed to sell at $35 when you sold the call, and now there is no way out of it. With the stock at $45, a 35 call will be worth at least $10 - you would have to spend as much to get out of the short call as you would make in the stock.

The basic problem with the covered call strategy is that is goes against the tried-and-true investing axiom of "cut your losses short, and let your winners run". A covered call does the opposite. It exposes you to maximum risk: stocks can go to zero. And it cuts your gains short: whatever strike price you might sell, a stock can go higher than that.

If you trade covered calls, here are some things to consider:

  • Understand the risk. As in the examples, you risk losing on the stock to the downside, and you risk giving up gains on the stock to the upside.
  • Understand that the premium you take in cannot make up for the risk. $1 per share in premium seems nice, but it can't make up for a stock that drops $5, nor a stock that rises $5 over the strike price.
  • Understand that the risk is YOURS. Brokers let anybody trade covered calls, because the strategy has no risk FOR THE BROKER. Your calls are covered - if the stock rises and you get called out, you have the stock to deliver, and your broker can't be hurt. YOU are hurt by taking losses on the stock, or being called out of the stock at a smaller gain than you might have had.
  • Always keep your eye on the STOCK. Have a stop loss point decided in advance, and stick to it. Set up an alert with your broker if you need to. Before you take a stop loss on your stock, you will need to buy back the covered calls you sold, which should give a small gain. NEVER sit watching a "nice" gain on the short calls and hoping for more, and all the while your stock is falling by two or three times that amount.
  • Understand that if you let the stock drop, you won't be able to sell calls against it at an attractive level. For instance, if you bought stock at $30, and now it is at $25, the 35 strike option will not be worth anything. You would need to sell the 30 strike to bring in premium, which means you give up all gain on the stock if you are called out. The further a stock drops, the harder it is to sell calls against it at the level you really want. You can find yourself selling calls at strike prices where you really don't want to get called out, just to keep making premium, and then having to buy the calls back when the stock happens to rise over the strike price.
  • Someone who has had success with covered calls in a bull market may find themselves actively searching for stocks to buy, based solely on how much they can make from selling calls against the stock. This is the road to ruin. At the end of a bull market or a bull phase in the market, you may find hot stocks that, for instance, have just risen to $55 quickly, and now you can sell the 60 strike for $7. You think, "wow, I can make $5 on the stock and $7 in premium!". The next thing you know, the stock has flamed out and is now at $30. You made $7 in premium, but lost $25 on the stock. Now what? you probably won't be selling calls at 60 or even 55 anytime soon.

The graph below represents the "bull call" strategy. Do you see the difference between this graph and the covered call graph? That's right - the bull call strategy is very similar, but has limited risk to the downside. If you like taking in some premium, but want to remove a lot of the downside risk, consider the bull call strategy instead of covered calls. The bull call still retains the limited gains to the upside.

Maybe your objection to a bull call compared to owning stock is that you don't get to hold anything for more than a month, and you don't get a second chance to be right. If that is the case, take a look at the bull call with LEAP anchor below. You are buying a LEAP call to substitute for the stock ownership, and you can hold the LEAP for a year or even two years. Then you can sell monthly calls against the LEAP the same as you would sell covered calls.

Now look at the graph of an in-the-money long call. It has limited risk to the downside, and unlimited potential gains to the upside. Why do people trade covered calls when they could trade long calls? Usually because they have become addicted to premium. It feels safe, it feels comfortable. They like the feeling of people paying premium to them, instead of paying premium to others. Another reason is that they just can't stand to take losses. Owning stock gives them the luxury of just sitting and waiting, even if their stock shows horrendous "unrealized" losses. Trading long calls that don't work out will bring the losses from unrealized to realized, and the investor can no longer fool himself into thinking he is successful, when actually he is not.

The real key to comparing the different strategies is to notice that every one of them is a loser if the stock falls much below 50. It does not matter if the loss is "realized" or "unrealized", it is still a loss. You wouldn't want to do any of these strategies if you were bearish. Since you are going to have some sort of a loss when your bullish bet is wrong, you want to have the best gains possible when you are right. The only strategies that give the best gains possible are the long call, or stock ownership without selling calls.

One tip for the covered call trader, is that you will often want to buy back short options expiring this month that are showing nearly all their potential gain, and sell other options expiring next month. If you do that in two trades, you will pay two trade commissions. If you do it as a "spread trade" most brokers will just charge one trade commission. Most online brokers have a way to enter option orders as a spread trade. For instance, buying back the November 30 strike, and selling the December 30 strike at the same time, is a spread trade.

A spread trade has the further advantage of letting you specify a limit for the whole trade, such as ".50 credit". If you trade each option separately, you may trade at the worst price on both trades instead of at midmarket. Or you may get a good fill on the buyback and have the stock move against you when you try to sell.

 

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