Covered calls are one of the most popular options strategies for generating extra income. But while they’re less risky than other option strategies, they aren’t risk-free. So, before using covered calls as part of your investment strategy, it’s critical to understand the risks and the steps you can take to mitigate them.
Let’s take a look at how covered calls work, what risks you’re assuming, and strategies to help mitigate those risks.
What Are Covered Calls?
Covered calls are an options strategy that involves selling a call option against an existing long stock position. By selling the call option, you agree to sell the stock at the strike price if the buyer exercises the option. But in return, you collect the option premium upfront as income. And you can still realize the profit between the current value and strike price.
Covered call option diagram. Source: TheOptionsBro
There are a few reasons to use covered calls:
- Income: You can generate income above and beyond a stock’s dividend without necessarily selling the stock.
- Hedging: You can hedge your bets against a drop in the stock price without selling any stock by using the option premium as a buffer.
- Exit Strategy: If you are already planning to sell at a specific price, you can generate extra income along with the sale.
Generally, covered call writers have a neutral to mildly bullish sentiment on the underlying stock. After all, if you were highly bullish, you wouldn’t want to cap your upside. And, if you were very bearish, you would probably sell the stock to avoid losses.
Risks of Trading Covered Calls
Covered calls are considered a low-risk strategy because there are limited and well-defined risks. If the stock drops, the buyer won’t exercise the option, and you keep the premium. If the stock rises, you agree to sell stock that you already own and still keep the premium. You can even use the strategy in most retirement accounts due to its low-risk profile.
That said, there are three risks to keep in mind:
- Opportunity Cost: A covered call strategy limits the upside potential of the underlying stock. If the stock rises sharply, you will miss out on the gains above the call option’s strike price. Of course, this is mainly a problem for long-term holders.
- Price Decline: The underlying stock price could fall below the breakeven point, resulting in a net loss on the position. For short-term traders using buy-write strategies to generate income, these capital losses will decrease your income potential over time.
- Assignment Risk: The underlying stock price could move past the strike price and cause the buyer to exercise the option. As a result, you have to sell the shares and deliver the underlying stock. To avoid assignment risk, you can buy back the call option. This could cost more than the initial premium received resulting in a loss.
Of course, the severity of these risks depends on the individual. For instance, assignment risk might be significant if it triggers a short-term capital gain for an investor in a high tax bracket.
Meanwhile, a drop in the underlying stock price might not matter to a long-term investor who never intends to sell the stock regardless of near-term performance.
Strategies to Mitigate Risk
You can take several steps to mitigate the risks of covered call strategies.
The most obvious way to reduce risk is to choose the right underlying stocks. Fortunately, covered call screeners can help you quickly find the best opportunities.
By incorporating fundamental and technical analysis, you can tilt the odds in your favor before you even establish a covered call position in the first place.
Some of the most important screening factors include:
- Potential Returns: Calculate the static return, if-called return, and expected return to understand how profitable the position could be in various situations.
- Fundamentals: Select stocks you want to own (e.g., one that you believe will increase in value over time). It’s hard to turn a profit on stocks that decrease in value over time.
- Implied Volatility: Implied volatility represents the market’s sentiment on a given stock. Look for stocks where IV is higher than you believe justified to tilt the odds in your favor.
- Upcoming Events: Look for any earnings, dividends, or other events that could impact the stock price or increase volatility. Avoid selling call options during these times.
If you find yourself in a position where the stock moves higher, you should be ready to make tough decisions. If you believe the price change is permanent either higher or lower, it may be best to sell and move on. But a temporary move could make rolling the option a better choice, enabling you to avoid taking an assignment and giving your investment thesis more time to play out. Keep in mind, early assignments are very rare. Unless a stock is significantly above the strike price, you likely won’t experience an assignment until after expiration.
There are five types of rolls to consider:
- Rolling Up: Buying to close an existing covered call and selling another covered call with a higher strike price.
- Rolling Down: Buying to close an existing covered call and selling another covered call with a lower strike price.
- Rolling Out: Buying to close an existing covered call and selling the same strike with a later expiration date.
- Rolling Up and Out: Buying to close an existing covered call and selling another with a higher strike price and later expiration date.
- Rolling Down and Out: Buying to close an existing covered call and selling another with a lower strike price and later expiration date.
If the underlying stock moves lower and you want to exit, you have the option to liquidate the entire position or convert the covered call into a diagonal spread. A much more complex strategy, the latter involves selling the underlying stock and purchasing a call option with an equal or later expiration than the short call. That way, you can deliver the stock if the price moves higher but have less capital and downside risk.
The Bottom Line
Covered calls are among the most popular and lowest-risk option strategies, but investors should still exercise caution. By carefully filtering opportunities and being prepared to manage sideways trades, you can mitigate these risks and maximize the odds of long-term success.
If you’re interested in trading covered calls, Snider Advisors provides free e-courses that show you how to select the best opportunities and manage covered call positions. Graduates from the course can also use the Lattco platform to automatically place and manage covered call trades without having to constantly monitor and manage their investments.