Covered calls are very popular with both retail investors and professionals. There are mutual funds and ETFs that employ the strategy exclusively or almost exclusively. Although they are conservative by nature, and good for earning consistent monthly income, they are not without risks.
The first risk is an unexpected tax event. Because American 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 prior to 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 get rid of his option that still has time premium in it then he would be better off just selling the option instead of exercising it.
But people do crazy things, including exercising options that have time premium remaining. That, in turn, might 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 open market and buy more with the proceeds from the assignment. The probability of an early exercise increases near an ex-dividend date, because the option holder may exercise to get the dividend. But again, if there is time premium remaining in the option then he is normally better off just selling the option rather than exercising it.
Next risk is the reduced upside potential above the strike price. The covered call writer can set the strike price to whatever value he likes, but one thing certain — whatever 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, earnings beat, increased guidance, competitor fails, etc) and the stock shoots up over the strike price then the covered call writer will not earn as much as he could have made if he hadn’t sold the call.
Downside protection is fun, 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 realize that you can still lose money with covered calls.
Lastly is the risk of chasing the highest yield. It’s tempting to use a covered call scanner to find the highest yielding covered calls and then just write those options. Rarely a good idea. A covered call scanner is just a starting point for further research. It will help you identify juicy premiums as an idea list to start from but then the you need to thoroughly research each one before investing. Covered calls have risks but they remain are one of the most conservative investments an investor can make, if used correctly.
If you would like to learn more call option tips go to this intriguing article.
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