SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Are Covered Calls a ‘Sure Thing?’


Most covered call writers enjoy the regularity and reliability of the position. In the majority of cases, the covered call will be profitable, even when underlying shares are called away. This assumes that the strike is higher than the basis in the underlying, and that the call writer understands the real limitations to the strategy.

Two primary flaws are found in covered calls, and these should be well understood by anyone decided to sell a call. First is the potential lost opportunity risk. If the underlying price rises far above the strike and the call is exercised, shares are called away – often well below current market value. A covered call writer needs to understand this risk and accept it in exchange for consistent income from the position.


A second flow is that profits are always limited. The maximum profit is the premium received for selling the call or calls; however, a very real risk of net loss also exists. If the underlying price falls below net basis, a paper loss results. This means a writer has to either realize the loss or wait it out in the hope that price will rebound in the near future. For example, a trader buys 100 shares at $40 and sells a call with a 42.50 strike, expiring in two months. Net premium received is 3 ($300). The net basis is $37 per share (purchase price minus premium received). If the underlying price falls to $32 per share, the trader allows the call to expire worthless, but now has a paper loss of 5 ($500). Should the trader sell shares and cut losses, sell another covered call, or wait it out in the belief the price will turn around?


The outcome should compare a limited maximum profit to unlimited possible losses. The risk is no greater than just owning shares, but it remains a risk just the same. A solution is to focus on underlying issues with exceptionally strong fundamentals (high dividend yield, 10 years of increasing dividends per share, annual high/low P/E between 25 and 10, growing revenue and net return, and a level or declining debt to total capitalization ratio). Strong fundamentals reduce volatility in stock prices over time, making covered calls safer than those for stocks with high volatility or erratic swings. But this is a deferred factor, not something seen to have an immediate impact:


Fundamentals matter, but it takes time for the market to recognize and fully absorb the improvement in a sector’s fundamentals. When the market is not perfectly efficient, the firm’s market value can differ from its fundamental value. (Zhang, D. (2003). Intangible assets and stock trading strategies. Managerial Finance, 29 (10), 38-56)


In other words, markets are inefficient. We hear this said a lot, but many people do not appreciate the meaning of the observation. Covered calls are not sure things and market inefficiency makes covered call writing higher-risk at times than options traders might believe. This is one reason n it makes sense to focus on very short-term expiration cycles. The longer a short option is left open, the greater the risk of unexpected and undesirable price movement. With expiration in one to two weeks at the most, time decay makes profitability more likely than the longer-term option selections.


Based on the dollar amount received for selling options, many prefer to go out two or three months (or more). But in comparing short-term and longer-term options on an annualized basis, the shorter-term option yields better net returns. In other words, selling 8 two-week options is more profitable than selling two 8-week options. The dollar value of premium can be deceptive, and the only way to make valid comparisons is to restate returns on the annualized basis. A second advantage in the shorter-term option is rapid time decay, reducing risk exposure and allowing traders to roll trading capital over many times to avoid the unexpected.


It also makes sense to avoid holding open covered calls in two conditions. First is quarterly dividend date. If a covered call is open in the days immediately prior to ex-dividend date and the call is in the money, traders can execute a dividend capture strategy, call away your shares, earn a quarterly dividend in one or two days, and then dispose of shares. This means you do not earn the dividend and you lose shares you want to keep. The second date to avoid is the day of quarterly earnings announcements. In case of an earnings surprise, the underlying can move in an unexpected way, often exaggerating the response to the surprise itself and leading to early exercise.


In any strategy, even the assumed “sure thing” of a covered call, risk assessment and equally important risk awareness should be taken into account in judging a position. What is your exit strategy with the covered call? One conservative approach is to close a position when a certain percentage of profits are realized; but options traders know that setting goals is easier than following them. It often is too tempting to hold off closing in the hope of more profits tomorrow or next week. No one can know for sure when profits will suddenly turn into losses, so setting a conservative goal and then taking action when that goal is reached, is a wise method for avoiding losses.


The lesson worth remembering in this is that there are no sure things in any form of trading. It’s true than covered calls are wonderfully consistent cash cows for traders, but anything can go wrong at any time, so traders need to (a) diversify risk exposure, (b) know the true risks to any strategy, and (c) limit exposure by time to expiration. Know when to take profits and set your rules. Then follow them consistently.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

Related articles:

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Q&A with Mental Game Coach Jared Tendler

    QUESTION: Thank you for taking the time to participate in a Q & A session with Steady Option. Let’s start with an introduction and a little bit of background on who you are and how you got here.

    By Jared Tendler,

    • 0 comments
    • 145 views
  • Using TLT Options to Increase Expected Returns of a Buy & Hold Portfolio

    TLT is the iShares 20+ Year Treasury Bond ETF that seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years. Even though US Treasuries typically act as a diversifying asset class to mainstream equities, many investors with long time horizons may not be interested in holding TLT in their portfolio because it would lower expected returns.

    By Jesse,

    • 0 comments
    • 115 views
  • Tax Efficient Trading Part II: Capital Gains Deferral

    In part I I illustrated how the preferential tax treatment of 1256 contracts could improve after tax returns of a PutWrite strategy over a long period of time. In this article, I’ll continue the illustration by switching from a PutWrite to an ETF BuyWrite (covered calls) strategy while holding pre-tax expected returns constant at 8%.

    By Jesse,

    • 0 comments
    • 668 views
  • Tax Efficient Trading Part I: The 1256 Contracts

    Cash settled index options like SPX, XSP, RUT and a few others receive special federal tax treatment where 60% of the gains are reported as a Long Term Capital Gain (LTCG) even if the contract was held for less than a year.

    By Jesse,

    • 0 comments
    • 613 views
  • SPY Short Puts vs. Put Spreads

    In this article I’ll be using the ORATS Wheel backtesting tool to compare the performance since 2007 of SPY short puts versus short put spreads. I’ll look at both risk and returns, and different ways of determining position size to adjust for the differences in risk between the two trades.

    By Jesse,

    • 1 comment
    • 1,275 views
  • Signs that you Are Ready to Start Investing

    If you want to build your wealth, you have to make sure that you invest your money. If you put money into a savings account and don’t earn any interest from it, this won’t work for you in the long term. Your money will lose value because of inflation, and this is the last thing that you need. So when do you invest?

    By Kim,

    • 0 comments
    • 782 views
  • One Year of Diversified leveraged Anchor

    I almost hate to keep saying it, but the Diversified Leveraged Anchor strategy keeps exceeding expectations and performing as designed. To remind our readers, Diversified Leveraged Anchor was created in April 2020 attempting to further increase performance, reduce risk, and to reduce volatility. 

    By cwelsh,

    • 5 comments
    • 1,745 views
  • Should I Pay Off My Mortgage Early Or Invest?

    Paying off a home mortgage early is a popular financial goal. Most people feel a level financial peace when their home is paid off that is beneficial in many ways. The most common approach to paying off the mortgage early is directly making additional principal payments to the lender on a regular basis.

    By Jesse,

    • 0 comments
    • 808 views
  • Option Order Execution Tips

    As a community of option traders, we all can relate to the occasional challenges of order execution. Best practices for avoiding errors as well as techniques for better potential execution will be the focus of this article.  Like countless others in the Steady Options community, I personally have traded thousands of option contracts over the last decade.

    By Jesse,

    • 17 comments
    • 2,367 views
  • What Trading Can Offer To A Newcomer

    For any first-time investor, one of the most important questions to ask is “why are you doing this?”. Getting into investment can be thrilling and open up new worlds for you, but it can also be draining both physically and emotionally, with long days and sudden market moves always a genuine risk.

    By Kim,

    • 0 comments
    • 999 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido