Column 10
Some Risks of Covered Call Writing
Last time we discussed why you would want to sell a covered call when owning a stock. This week let’s take a look at some of the risks associated with the strategy, or
- What can go wrong when you sell a covered call?
- Are you better off selling the call?
1) If you are concerned your stock may decline in price over the coming several months, but still want to retain ownership of the stock, selling a call option provides cash income and protection in case the stock does decline.
Selling the call option provides cash, which you can use to offset some, or all, of a future loss, if the stock declines. The risk is the stock may decline by more than you received for selling the call. In this case, you will not have acquired enough protection and you will have a loss. You would have been better off selling the stock, rather than selling the call. But, since you wanted to retain ownership, you did not consider selling the stock. Thus, although you lost money, this strategy has worked for you because your loss has been reduced.
2) You are satisfied with your stock, but are concerned the overall market may be vulnerable to a decline. Selling a call option provides a limited amount of insurance in case your fear comes true
There are two risks in this scenario. First, if the market declines, you may find yourself in a situation identical with number 1 above. It is possible your stock may lose more than the protection you received from selling the call, resulting in a net loss.
Second, you may find your stock has increased in price regardless of whether you were right about the market declining. If your stock has a large price increase, you will not be able to collect the entire increase, as you cannot sell your stock for more than the strike price of the option. You have a profit because you sell your stock for the price you chose (strike price) plus you keep the cash from the option sale. But this profit may be less than you would have made if you did not sell the call. This profit reduction is a result of your fear of a market decline, so it is not the fault of the option strategy. In fact, the option sale accomplished its intended purpose – it provided insurance in case your stock declined in price.
3) Your stock has not been making money for a period of time and you want the investment to generate some income. Selling a call option provides cash now.
Selling a call on a stock that has not been performing well is a good idea. When you sell the option, in return for the immediate cash from the sale, you must give up the chance to make a killing if the stock suddenly spurts upwards. This is always a risk when selling a call option – your upside gain is limited.
4) You believe your stock is a good long-term investment, but that it will not rise significantly in the next 6 months.
This situation is very similar to number 3 above. You sell the call option in order to generate income for a period of time in which you do not expect to make a profit from your stock. The option sale puts cash in your account now, and the risk is the stock makes a big move upwards. Once you sell the call, the maximum price you can receive for selling your stock is established. Of course, if the option later expires worthless, you no longer have any limit to your future selling price.
Next week we will take a look at the risk involved with the other two strategies from last week’s column. They require a more detailed discussion.
So far, none of the risks described are big enough to discourage you from the use of the covered call writing strategy.
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