Covered calls are extremely popular with both retail investors and professionals. There are mutual funds and ETFs that employ the strategy exclusively or almost exclusively. Although covered calls are conservative by nature, and great for earning consistent monthly income, they are not without risks.
Taxes are the first non-obvious thing to look out for. In addition to causing a lot of short-term gains/losses there is a risk that your core long term holdings will be called away, thus creating a tax event you weren't anticipating. This can happen due to early exercise. If the option holder decides he wants your stock, even if there is still time premium in the option, it is within his rights to exercise his option and take your stock. Although you receive the strike price as compensation, you may end up with a tax event you didn't want. As rational investors know, it doesn't make financial sense for the option holder to exercise if there is still time premium remaining in the option.
Hard to believe , I know, but there are some uninformed actors involved in the stock market. They do crazy things like take early exercise on options that still have time premium (whereas it would make more financial sense for them to just sell the option so they didn't have to forfeit the time premium). Now, if this happens in an IRA account it doesn't matter (since it's a non-taxable account). But in a taxable account it can cause tax problems. Usually you only have to really look out for this as an ex-dividend date approaches, and only then in options that have just a penny or two of time premium.
Another risk is the reduced upside potential a covered call writer has. Once you write an option for a certain strike price, that is the most you are going to get for your stock, no matter how high it goes before expiration. If there are any positive surprises before expiration then you will only benefit up to the strike price, and not beyond. You will still make money, just not as much as you could have.
Covered calls do not prevent losses. Some investors feel a sense of insurance because of the call premium they received when they sold the call. However, it won't be enough to protect against losses if the stock drops below the break even point of the covered call trade (stock price paid less the option premium received). While there is some downside protection in a covered call position, it is not infinite. Stocks can drop significantly in a short period of time. In this case the covered call writer will lose less than the buy and hold investor, but it may still be a loss nonetheless.
Lastly is the risk of chasing the highest yield. It's tempting to use a covered call scanner to identify the highest yielding covered calls and then just blindly write those options. Rarely a good idea. A covered call scanner is merely a starting point for additional research. It will help you identify juicy premiums as an idea list to start from but then the you need to carefully research each one before investing. Covered calls have risks but overall they are one of the most conservative investments a person can make, if used correctly.
Taxes are the first non-obvious thing to look out for. In addition to causing a lot of short-term gains/losses there is a risk that your core long term holdings will be called away, thus creating a tax event you weren't anticipating. This can happen due to early exercise. If the option holder decides he wants your stock, even if there is still time premium in the option, it is within his rights to exercise his option and take your stock. Although you receive the strike price as compensation, you may end up with a tax event you didn't want. As rational investors know, it doesn't make financial sense for the option holder to exercise if there is still time premium remaining in the option.
Hard to believe , I know, but there are some uninformed actors involved in the stock market. They do crazy things like take early exercise on options that still have time premium (whereas it would make more financial sense for them to just sell the option so they didn't have to forfeit the time premium). Now, if this happens in an IRA account it doesn't matter (since it's a non-taxable account). But in a taxable account it can cause tax problems. Usually you only have to really look out for this as an ex-dividend date approaches, and only then in options that have just a penny or two of time premium.
Another risk is the reduced upside potential a covered call writer has. Once you write an option for a certain strike price, that is the most you are going to get for your stock, no matter how high it goes before expiration. If there are any positive surprises before expiration then you will only benefit up to the strike price, and not beyond. You will still make money, just not as much as you could have.
Covered calls do not prevent losses. Some investors feel a sense of insurance because of the call premium they received when they sold the call. However, it won't be enough to protect against losses if the stock drops below the break even point of the covered call trade (stock price paid less the option premium received). While there is some downside protection in a covered call position, it is not infinite. Stocks can drop significantly in a short period of time. In this case the covered call writer will lose less than the buy and hold investor, but it may still be a loss nonetheless.
Lastly is the risk of chasing the highest yield. It's tempting to use a covered call scanner to identify the highest yielding covered calls and then just blindly write those options. Rarely a good idea. A covered call scanner is merely a starting point for additional research. It will help you identify juicy premiums as an idea list to start from but then the you need to carefully research each one before investing. Covered calls have risks but overall they are one of the most conservative investments a person can make, if used correctly.
About the Author:
Born To Sell, http://www.borntosell.com, is a site for covered call options. This cool site has a comprehensive newsletter on covered call options.
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