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.