Beware the Pitfalls of Selling Covered Calls

Many people will advocate the selling of covered calls for monthly income and will tout monthly returns of 2-5%. They will emphasize the conservative nature of the investment and state that it is so safe that it can be done in an IRA. They will state that is safer than buying and holding stocks because you can reduce your potential loss by the amount of premium received. All of these facts are true. Even I demonstrate how you might generate a monthly income by selling covered calls.

But I think it is important to be fully informed. Rather than emphasize the rewards in this article, I would like to emphasize the risks. Investing involves a balance between reward and risk; you need to know both sides of the equation in order to make good decisions.

Compared to buying a stock outright, the risk of buying a stock and selling a covered call is indeed less.  I could certainly buy Apple stock (AAPL) at $137 per share and would be risking $137 per share should AAPL go bankrupt.  On the other hand if I did a buy-write and purchased the stock for $137 while selling the July 140 call for $5.10, my money at risk would be lower at $131.90 per share.  The problem is that my reward is capped at $140 now.  If AAPL goes to $150, the opportunity cost to me is $10 per share.  The problem is that I don’t know what AAPL will do between now and the third Friday of July.  Therein, lies the rub.  It is impossible to predict the future, so it is up to the individual investor to determine the balance of risk and reward that is acceptable.

Option premiums are meant to reflect, to the best of the ability of professional options traders, the known risks that a particular stock will move over the designated period of time. If two stocks have the same price, but one has an option premium that is twice as high, you can assume that the one with the higher priced option has more volatility. Volatility can be good when it works in your favor but catastrophic when it doesn’t.

If you solely pick which stocks to purchase based upon the option premium that you can get when you sell the covered call, then you are likely to end up with a portfolio of highly volatile stocks. The stocks that have gone up get called away, and you are left with a portfolio of stocks that have not gone up or worse have dropped substantially. It is very easy for a volatile stock to lose 50% of its value with a bad earnings report. A few dollars in option premium is little consolation when half your capital is gone. What you have done is accepted the majority of the risk for your stocks but given up the majority of the reward. That is almost a guarantee that you will eventually lose money when selling covered calls.

Lest I scare you, it’s not that selling covered calls are bad. It can be a useful technique to enhance income in a portfolio that you would otherwise be holding for the long term. But, if you are just picking stocks that pay out the highest premium, you will ultimately be disappointed.