Writing Covered Calls: What Can go Wrong?

The Best Laid Plans...

What Could Go Wrong?. flickr.com

Covered call writing (CCW) is a popular option strategy. It works well for beginners as well as more advanced traders. 

The strategy:

     Buy shares (in 100-share increments) of a stock that you want to own
     Sell one call option for each 100 shares owned.
     Rationale: In return for accepting a limited upside profit, you get to keep the option premium.

 

Imperfect Strategy

CCW may be a conservative strategy and it does earn a profit more often than buy and hold, but it is not risk free.

 Therefore it is reasonable to ask: What do you have to lose when writing covered calls? 

1) Stock market decline. If the underlying stock undergoes a major price decline, you will lose money. The premium received when selling the call will offset only a portion of the loss associated with stock ownership.  

If you are a buy-and-hold investor who would not sell your holdings during market declines, then this is not a risk factor for you. In fact you will be glad to have sold the option, because it reduced the loss resulting from the price decline.

If you were to change your mind and decide to sell the stock at any time that you remain short the call option, then you must (some brokers will not enforce this) cover (i.e., buy to close) the call option. If you sell stock without buying the option, you would own an uncovered call position, and that is too risky for most traders.

2) Missing out on selling stock at your target price.

If the main objective was to sell stock (@$40, for example), you might lose the sale. Consider what happens when the stock price climbs above $40 during the life of the option, and then falls below that price when the options expire. The call owner will not exercise his/her option and you will no get tot sell the stock.

If you entered a good ‘til cancelled sell order (instead of writing a covered call), then the stock would have been sold when it reached your price. The big risk is that the price decline (after it trades at $40) may be large, and you will still own the stock and be unhappy with its current market price. The profit from the call sale reduces the loss, but this would not be a good result.

3) If your stock price surges through the strike price and makes a major advance, you will have lost the opportunity to sell stock at the higher price because you sold the call option. You still have a good profit (some mistakenly believe they lost money in this situation) -- and this is a good result -- but this profit is less than it could have been without the option sale. Remember: even without the option sale, you might have entered a good ‘til cancelled sell order -- at a price that is far lower than the eventual high price.

I urge traders to not think of this as a bad result. You had a good reason for selling the call option, even though (this time) it would have resulted in a larger profit if you had not sold it.

4) If you own a dividend paying stock, it is possible you will not collect the dividend.

The owner of the call option has the right to exercise the call at any time. It is possible he/she will choose the day before the stock goes ex-dividend. That means you will be and must sell your stock and not receive the dividend. This is not all bad news because you get to sell stock at the strike price, and this sale occurs before expiration. That allows you to reinvest the proceeds of the sale and put the money back to work.
 

There is another risk associated with writing covered call options. It is impossible to quantify, for it is a psychological risk. Some people want the best possible result with every investment -- and are never satisfied with less. If this is how you view investing, then this strategy is not for you. CCW works best for those who prefer steady, slightly better than average returns.

Those are the major risks associated with selling covered calls. I believe these risks are small when compared with the benefits. Most investors should at least consider CCW for a portion of their investment funds.