How Risky Are Covered Calls?

Identifying and Managing Call Writing Risks

How risky are covered calls? That's an interesting and important question because selling covered calls is certainly not without risk.

Covered call writing is often touted as a conservative option trading strategy. There is some general truth to the portrayal, but as with all such generalities, not a whole lot of insight.

Unfortunately, the internet is filled with superficial and impartial information written by individuals lacking either the aptitude or the self-interest to drill down on the subjects they cover.

So let's take a few minutes and specifically address the risks associated with writing calls.

Option Risks - Switch or Dial?

I like the How risky are covered calls? question because it gives me the opportunity to reiterate what I think is one of the most important lessons of option trading - namely that options are a risk dial, not a risk switch.

In fact, the main role and original rationale for stock options is to have a vehicle for the trading and management of risk. Options are often seen as risky, but that's only part of the story.

The reality is that options are called options because that's exactly what they give you. Broadly speaking, you can use them to assume the risk of others in exchange for some form of compensation (the basis of credit spreads) or some form of capital gains (the basis of debit spreads).

Of course, it works in the other direction, too. You can use options to, in effect, outsource your own risks (i.e. hedging strategies) in exchange for some form of a cash payment or the sharing of your own position's potential capital gains.

And again, the risk here is a dial, not a switch. With options, it's you, the individual, who determines the level of risk you're willing to assume or what level of risk you desire to outsource.

The more you get this, the less mysterious options are.

Covered Call Risks - Downside Risk

If you're at all unfamiliar with this strategy, or just want a refresher, be sure to check out the covered call basics page, or the Covered Calls Overview section for a complete listing of covered call resources this site provides.

Selling calls against stock you own can be seen as a form of reducing the cost basis on those shares by the amount of the premium your receive.

For example, if you buy 100 shares of the XYZ Zipper Company at $30/share and you then proceed to write a $32.50 call on the stock and receive $1/contract in premium (or $100), then assuming the call eventually expires worthless, you have in effect lowered your cost basis from $30/share to $29/share (though not for tax purposes).

That's great, of course, and one of the main reasons why covered calls are seen as conservative - in this example, you just gained a $1/share advantage over a simple buy and hold strategy.

However - and this is a big however - selling calls provides only limited downside protection (and sometimes, depending on how you set them up, almost no downside protection at all).

So what happens if instead XYZ promptly drops to $24/share? That $1/share advantage you held over the buy and hold investor is small comfort when the bottom falls out of your stock.

Covered Call Risks - Upside Risk

Upside risk? How can you have upside risk? It's true that you won't lose money if you write a call on a stock and it trades higher through and beyond your strike price.

But here's the key drawback - you won't see any capital gains above that strike price either. And when a stock really breaks out, you're probably going to feel sick at how much money you've left on the table.

In fact, many covered call detractors consider the upside risk to be greater than the downside risk. Remember that selling a call is more or less a neutral to slightly bearish bet (although it's often described as neutral to slightly bullish - I disagree - you may own the stock, but you've also opened a short call option position).

Going back to our XYZ Zipper Company example, what would happen if the stock reported blowout earnings or announced they were going to be acquired at a premium and the stock suddenly shoots up to $40/share?

If you had written the $32.50 call, you'd be looking at an additional $7.50/share in capital appreciation that you're not going to get.

Ouch.

How Risky Are Covered Calls? How Risky Are You?

Covered call detractors will point to both of these risks and argue that the entire call writing model is flawed. In fact, it does seem to fly in the face of that old trader's mantra of "Cut your losses quickly and let your winners run."

It forces you to sell stocks that make big moves higher (and without participating in some, most, or all of the capital gains). And it also encourages you to hold on to stocks that are falling. The cynical interpretation then becomes: "Cut you winnings quickly and let you losers run."

Although I understand the validity of this argument, I believe that there are smarter and more effective methods of writing calls that can mitigate much of the inherrent risk.

Remember - options are a risk dial, not a risk switch, and just about any trade can be made to be more conservative or more aggressive.

The better question than "How risky are covered calls?" is the more insightful question, "How risky are you?"

Managing Call Writing Risks

There are, of course, multiple components involved in selling calls. How you address these components determines to a large extent how well you're going to navigate the various risks associated with covered calls.

The components in question are:

Understanding Your Own Objectives - This really is the foundation of any successful trading or investing endeavor. You really must identify and articulate your covered call objectives. Are you an income trader, aiming for relatively consistent double digit returns each year at the sacrifice of missing out on the occasional really big gains and really big years? Are you an active covered call trader with a more hands on and technical approach as you look to aggressively maximize total returns? Or are you looking to use covered calls in a Leveraged Investing manner and safely boost the returns on your long term portfolio?
Stock Selection - Arguably the most critical decision you make in the covered call process is which stocks you write calls against. I spell out 5 Criteria for Successful Call Writing Stock Selection in Best Stocks for Covered Calls.
Market Conditions - Obviously general market conditions will play a big role in the outcomes of your trades. Sell calls during a big bull market and you won't keep up - sell calls during a severe bear market and you'll still rack up plenty of losses. Just because you write calls, doesn't mean you always have to write calls. Sometimes it's better to just sit on the sidelines and enjoy the flexibility a trading mindset sometimes has over an investing mindset.
Strike Price - The strike price you select also has major implications - for more in depth information, see Best Covered Call Strike Prices - Understanding Strike Prices When Writing Calls and Picking the Best Strike Price for Covered Calls - 3 Strike Price Strategies for Selling Calls.
Expiration Date - And don't overlook the importance of the expiration date when writing calls, which is explored in greater detail in Best Expiration Date for Covered Calls.