Covered Call Writing Risks
You may be concerned with the lost opportunity risk associated with potential future profits in the stock. Once you sell a call, you commit yourself to selling 100 shares at the striking price, even if the stock's market value rises far above that price. Owning 100 shares covers the short position in the call; it also limits potential profit overall if the call is exercised. Profits are not limited as a certainty; if you close the position or roll into a different short position, or if the call expires worthless, then the lost profit risk is eliminated.
Smart Investor TipThe covered call seller has fewer risks than others because it is a safe, conservative strategy. Even if the stock falls in value, writing calls provides you with downside protection.
By properly structuring a covered call writing strategy, you can learn to manage the risk of losing potential future gains, in exchange for predictability and the certainty of current profits. The covered call writing strategy is going to produce profits consistently when applied correctly. So a very good return on your investment -- including double-digit returns -- is possible through writing covered calls. You might lose the occasional spectacular profit when a stock's price rises suddenly; but for the most part, your rate of return will exceed what you could expect in your portfolio without writing covered calls. Some pitfalls to avoid in your covered call writing strategy:
- Setting up the call write so that, if exercised, you end up losing money in the underlying stock. This is possible if you sell calls with striking prices below your original basis in the stock.
- Getting locked into positions that you cannot afford to close out. If you become involved in a high level of covered call writing, you may eventually find yourself in a position where you want to close out the calls, but you do not have the cash available to take advantage of the situation. You need to set up an adequate cash reserve so that you can act when the opportunity is there.
- Writing calls on the wrong stock. When you begin comparing premium values, you might spot an unusually rich time value in a particular option. The stock is likely to be volatile, which is the cause of the exceptionally high premium in the call; this means that the risks associated with owning that stock are greater than for less volatile issues.
By Michael C. Thomsett