Examining Covered Call Opportunities And Risks
Covered calls are very popular with both retail investors and professionals. There are mutual funds and ETFs that use the strategy exclusively or almost exclusively. Although covered calls are conservative by nature, and good for earning recurring monthly income, they are not risk-free.
Taxes are the first gotcha. In addition to generating a lot of short-term gains/losses there is a risk that one of your core long term holdings could be called away, thus creating a tax event you weren’t anticipating. This can happen due to early exercise. If the option buyer decides he wants your stock, even if there is time premium in the option, it is within his rights to exercise his option and take your stock. Although you receive the expected strike price as compensation, you may end up with a tax event you didn’t want. As rational investors know, it doesn’t make economic sense for the option holder to exercise if there is time premium left in the option.
But some investors do crazy things, including exercising options that still have time premium remaining. That, in turn, could cause a tax event for you if the stock is held in a taxable account. If your stock is in an IRA (or other non-taxable account) then it’s no big deal. If you still want to own the stock just go into the market and buy more with the proceeds from the assignment. The possibility of an early exercise increases near an ex-dividend date, because the option holder may exercise to capture the dividend. But again, if there is time premium still in the option then he is usually better off just selling the option rather than exercising it.
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 rises before expiration. If there are any positive surprises before expiration then you will only profit up to the strike price, and not beyond. You will still make money, just not as much as you could have.
Some people think that covered calls will prevent losses. If that were true then it would be the only strategy investors ever used. What is true, though, is that they will reduce your losses. And if a stock goes down then the covered call writer loses less than the buy and hold investor. So, on a relative basis it *is* better, but it’s still possible to lose. The call premium you receive does offer some downside protection, but it is not unlimited. If the stock drops below the net debit for the trade (stock price paid – option premium received) then you will lose money.
Finally, a large risk when investing in covered calls is chasing yield and not doing your homework. All is fine if you want to use a covered call screener to find high yield covered calls, but that’s just the first step, not the last. You will still need to do thoughtful research to understand why the yield is so high on those options. Although there are risks in covered calls it is true that they are the most conservative option-based strategy and can make good profits if used wisely. Like any tool, it’s possible to overuse or misuse them, too.
If you would like to find out more call option tips go to M covered calls.
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