| Examining Covered Call Risks And Opportunities |
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| Written by Keith Pelletier |
| Wednesday, 20 April 2011 11:58 |
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Covered calls are very popular with both professionals and retail investors. There are ETFs and mutual funds that use the strategy exclusively or almost exclusively. Although covered calls are conservative in nature, and good for earning consistent monthly income, they are not risk-free.
Covered calls are very popular with both professionals and retail investors. There are ETFs and mutual funds that use the strategy exclusively or almost exclusively. Although covered calls are conservative in nature, and good for earning consistent monthly income, they are not risk-free. The first risk is an unexpected tax event. Because U.S. style options can be exercised at any time prior to expiration, the seller of the option (i.e. the covered call writer) has a risk that the buyer will exercise the option before expiration. Normally it doesn't make any sense for the buyer to exercise if there is still time premium remaining in the option, because the buyer forfeits the time premium when he exercises. So if he wants to close out his option that still has time premium then he would be better off just selling the option instead of exercising it. Hard to believe but there are some irrational investors involved in the stock market. They do crazy things like do early exercise on options that still have time premium (whereas it would make more economic 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 events you may not want. 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 tiny bit of time premium. Next risk is the lack of upside potential above the strike price. The covered call writer can set the strike price to whatever value he likes, but one thing is true -- whatever value he sets it to is the most he will receive for his stock between today and expiration. If there is a happy surprise of any kind (M&A takeover, increased guidance, earnings beat, competitor fails, etc) and the stock rises above the strike price then the covered call writer will not earn as much as he could have made if he hadn't written the call. Downside protection is comforting, but should not be leaned on as a savior to prevent all losses. The option premium you receive will cushion the first part of any loss but if the stock drops significantly then you will probably still have a loss (less than a buy and hold investor, for sure, but it's still a loss). Often cited as the tradeoff for putting a cap on your upside potential, it is definitely a good thing but just be aware that you can still lose money with covered calls. Finally, a large risk when investing in covered calls is chasing the highest yield and not doing your homework. All is well and good if you want to use a covered call screener to identify 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 misuse or overuse them, too. DISCLAIMER: This article is provided as information only and is not to be taken as financial advice. For new info on option trading please visit this website. |