Covered Call Writing Risks

The seller of uncovered calls faces potentially large losses. As a covered call writer, your risks are reduced significantly. That risk is limited on the upside to lost future profits that do not always take place. On the downside, the risk is the same for simply owning shares; a decline in price represents a paper loss. The call writer discounts the basis in stock, providing a degree of downside protection and lowering those risks. When you write calls against stock using striking prices above your original basis, you have created a built-in profit factor.
Whereas uncovered call selling is very high-risk, covered call writing is on the opposite side of the spectrum; it is very low-risk.

Smart Investor Tip

The 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.

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.

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:
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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