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.

Dangers of the covered call


The covered call. That popular, strategy described by many as risk-free or at least so low-risk that you can’t go wrong. Or can you? A few dangers of the covered call should be described or, more accurately, a realistic point of view about this “sure thing” trade. A few points worth remembering:

1. Risks are low, but so are maximum profits

The risks of covered calls are low, without any doubt. Properly selected calls – slightly out of the money, expiring sooner rather than later – are going to yield double-digit annualized returns. But on the other side of this trade is a specific limitation of profits. The most profit you can earn on the call is the call premium; additional profits come from capital gains and dividends, adding up to a potentially substantial number. But the profit on the call itself is very limited. Even if the capital gain is a nice high number, it can only go so far. For many, the best time to open a covered call is when paper profits have accumulated already, and exercise would combine call premium with a big capital gain in the underlying.

 

2. If underlying declines too far, you have a paper loss

A loss is possible. Too often, traders overlook what happens if the underlying tumbles. With recent stock market volatility, traders have had a wakeup call in many cases, discovering that their sure thing was not all that sure. For example, Amazon.com (AMZN), a favorite among options sellers, was at $1,775 on December 10. Two weeks later, it had fallen to $1,350 per share, a drop of 425 points. If a trader had purchased 100 shares at $1,775 and sold a one-month ATM contract for 85, that would seem liked a perfectly reasonable buffer, under normal circumstances. But over two weeks, the loss in stock of $42,500, adjusted by option premium of $8,500, translates to a paper loss of $34,000. The stock rebounded, of course, but on that day of the drop, the once-safe covered call would have to be perceived with more caution.

 

3. Recovering from a loss might take time or require facing higher risks

The time required for a depreciated stock to rebound is going to vary. Amazon tends to act with high volatility, making options richer than many other choices, and potentially likely to rebound quickly. But there are no promises. Some stocks decline and stay down for a long time. For example, IBM was at over $150 per share at the beginning of October. By December 26, it ended up at under $114, a difference of 36 points, or a 24% drop in value per share. A trader selling an ATM covered call expiring in October at the strike of 150 would have made a profit of about $150. When this expired worthless the stock was worth about $130 per share. The $150 profit on the call was offset by a loss of $2,000 on stock, a net drop of $1,850. Waiting for the stock to rebound was difficult as the stock continued falling another 20 points to a low of December 24 of about $100 per share. When will this recover? Given the degree of paper loss, a recovery strategy (for example, selling uncovered puts) would expose a trader to continuing risk without any guarantee of getting back the lost value.

 

4. The danger of converting to an uncovered position should not be ignored

Traders learn more from mistakes and surprises than from matters going as expected. For example, executing as series of recurring trades requires diligence and observation of trade timing. For example, a trader buys 100 shares and sells an ATM covered call expiring in two weeks. One week later, the underlying has jumped 25% in value. The trader decides to take profits and sells shares. However, in overlooking the open short call, the trader now is left with a problem. The covered call has been converted to an uncovered call. Making matters worse, with the big move in the underlying, the short call is in the money – and the stock is moving up every day. Chances are that this position will be exercised, wiping out the profit on stock and more, possibly turning the entire trade into a net loss. 

 

5. Being classified a pattern day trader has consequences

The “pattern day trader” rule is that if you execute trades on the same underlying four times or more within five consecutive trading days, you come under scrutiny and probably will be labeled a pattern day trader. Given the nature of options trading, it would not be difficult for these volumes of trades to occur. Once your broker classifies you as a patter day trader, you are required to maintain at least $25,000 in your margin account. This is bad enough; but getting the label removed requires a few steps and could be difficult if not impossible. Before embarking on a high volume of trading activity, study the rules and take steps to avoid being viewed as a pattern day trader. 

 

6. Potential tax consequences include losing long-term tax treatment

One oddity of options taxation is the “qualified covered call” rule. You can sell a call at any strike you want; but if you pick a strike two levels below the current price of the underlying, it probably is an unqualified covered call. This means the count toward the one-year holding period for long-term capital gains treatment is tolled and will not start again until the unqualified call is bought to close. Here’s an example: You bought stock 8 months ago for $43 per share and currently it is worth $65. You sell a covered call expiring in 5 months for a 55 strike. The rationale is that premium is rich, and exercise would produce profit in both the call and the underlying. Because the total holding period at expiration would be 13 months, it would be a long-term capital gain, right? No. Because the covered call was unqualified, the count toward the one-year hold is stopped until the call expires, is closed, or gets exercised. Even if exercise occurs on the last trading day 13 months after you bought stock, the 12-point capital gain will be short-term.

 

Options trading is always complicated; but many traders think the covered call is easily understood and low-risk. That is true to a degree, but some potential problems can make the position less attractive. It does not have to be as complicated at it might seem, as long as you are aware of the possibilities above and take steps to avoid problems.

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 website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

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

  • 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,

    • 7 comments
    • 600 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
    • 101 views
  • Updated: The Performance Gap Between Large Growth and Small Value Stocks

    Eight months ago on July 21st 2020 I posted an article, The Performance Gap Between Large Growth and Small Value Stocks. Over the long-term small cap value stocks have outperformed large cap growth stocks, although not over more recent history.

    By Jesse,

    • 0 comments
    • 262 views
  • 6 Ways to Invest Your Money That Aren't Cash Savings

    It’s always a good idea to keep some of your money in cash so if there is an emergency and you need money in a hurry, you can access it without having to worry. However, cash savings are not your only option if you have money left over at the end of the month, and there are a lot of other options that could bring greater returns.

    By Kim,

    • 0 comments
    • 318 views
  • Jade Lizard Options

    The jade lizard is one of those bullish spreads with limited maximum profit, and no risk on the upside. It is a combination of a short put with a short call spread . The credit this creates is higher than the span of the spread. To set this up, two actions are required:

    By Michael C. Thomsett,

    • 0 comments
    • 546 views
  • Are Your Emotions Trying To Tell You Something?

    As a trader, you may find yourself frequently trying to ignore or rationalize emotions.  You may have even created your own “solutions” to manage them. You exit early to lock up profit and avoid a potential blow-up if the trade turns against you.

    By Jared Tendler,

    • 0 comments
    • 360 views
  • Stock Trading Basics: 5 Rules for Successful Stock Trading

    You might be a stock trader, or just interested in learning more about how to trade and make the most out of your stock investment. Regardless, successful stock trading is not that easy. You must first have the financial capital to start and a very great endurance for risks.

    By Kim,

    • 2 comments
    • 505 views
  • Hourly Financial Advice for DIY Investors

    A large percentage of the Steady Options community consists of do it yourself (DIY) investors who prefer to manage their own trading and long-term investing accounts. This is a great way to gain firsthand experience about how markets work, but at times it may be beneficial to get professional input on investing and other personal financial planning decisions.

    By Jesse,

    • 0 comments
    • 309 views
  • Seagull Spreads

    Some varieties of call and put spreads are also called seagull spreads. It is so called because it contains a body and two wings. If the body is short, the wings are long, and vice versa. This 3-contract strategy includes two calls and a put, or two pouts and a call.

     

    By Michael C. Thomsett,

    • 0 comments
    • 435 views
  • Are Hedge Funds Good Investment for You?

    Right now, people are feeling at a bit of a loss as to what to do with their money. Those who usually invest are probably well aware that the market is pretty tricky right now. During unprecedented times, there are often unprecedented outcomes when it comes to investments.

    By Kim,

    • 0 comments
    • 436 views

  Report Article

We want to hear from you!


I think we can view a covered calls as a stock filter; they call away all the good stocks and leave us with poor performing ones. And of course the risk is huge! We're risking the entire cost of the stock,  minus the tiny premium we received in the sale of the call. Wow, have marketers ever been so wrong as with the covered call? Thank you for telling us the truth, Kim!

Share this comment


Link to comment
Share on other sites


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