Pros and Cons of Selling Covered Calls

 

In case you didn’t know, selling covered calls can be a great way to create consistent income. Of course, there’s no such thing as a free lunch, so you need to be aware of what you’re getting into before you sell your first calls.

 

You can always find someone who’ll swear it’s the easiest way to make money. Then there are others who won’t touch a covered call with a ten-foot pole. As with any investment, there are risks and benefits associated with trading covered calls.

 

Just because someone else has had success with a particular way of investing doesn’t mean that it is a guarantee of profits for you. On the other hand, if you come across someone who won’t even think of selling call options it’s not necessarily a sign that you should shy away from that strategy.

 

Covered calls have a lot of things going for them. However, you do need to know what you may have to sacrifice by implementing this investment vehicle.

 

So since no one likes to hear bad news, let’s discuss the benefits to your portfolio should you decide to write calls on stocks that you own.

 

Covered Call Pros

 

Monthly/weekly income. Depending on how you choose to sell covered calls, you could potentially get paid every week. With many equities offering options that expire every week as well as the third Friday, you get 52 potential pay dates a year.

 

While you may not be able to profitably sell a call every single week, the potential to do so is still there. Just having that option (no pun intended) puts a check in the pro column for covered calls.

 

If you don’t want to manage your account so closely to sell weekly call options you could choose to just sell the monthly contracts. This would cut down on how actively you might have to monitor the stocks in your portfolio. Having to only execute 12 trades a year is what comes to mind when people think of covered call income.

 

Adding to dividend income. By selling a covered call on shares that you are just holding in your portfolio, you can generate an additional revenue stream above your dividends and stock appreciation. Many people just hold a stock for the dividends, but why not make extra profits from covered call selling as well? By knowing when to sell call options (and if/when you need to buy them back) you can accelerate the rate at which your stock account grows in value.

 

Great for sideways and bull markets. Covered call writing allows you to profit from a stock that is trending sideways. If your plan is to sell a stock once it has risen a few dollars you can sometimes be frustrated when one of your holdings just dances around the same price you originally paid for it. Covered calls can give you an extra cash flow while you are waiting for your stock to rise in price.

 

The premium you collect from selling the call option(s) is yours to keep no matter what. Even if you are not called out at expiration, you still hold on to the cash you received from opening the position. You also don’t have to sell the stock if it doesn’t close over the strike price you sold the options at.

 

Reduces your cost of buying stock. An often overlooked benefit to selling a covered call is that it can actually lower the cost of buying shares of stock. If you buy shares and at the same time sell your covered call this is what’s known as a buy write. If you were to buy stock and then sell covered calls at a later point in time that would just be selling a covered call.

 

Let’s say that you wanted to purchase shares of stock that were currently trading at $30 per share. The $30 call option for that stock is priced at $1.00. If you were to buy the stock and simultaneously sell the call options, buying the stock would only cost you $29 per share ($30 for the stock minus the $1 you receive for selling the call option). Even if you only sell covered calls to purchase stock, it still greatly lowers your cost for each position.

 

With a stock that you’ve been selling covered calls on for some time, you can significantly reduce your cost basis. As discussed earlier, adding covered calls to dividend investing creates additional income and helps to buy more shares faster if you reinvest that income.

 

Downside protection. The premium you receive when you sell the covered call can help protect you in case the stock price starts to fall. Since you get to keep the money from selling the calls no matter what, if you find yourself having to sell a stock that’s in trouble you won’t be out as much out of your pocket.

 

Covered Call Cons

 

Limiting your profit. Selling call options against your stock automatically caps your profit potential should the stock sharply go up. If you bought 100 shares of stock at $30 and sell a covered call at the $35 strike price, you miss out on any profit if the stock closes above $35 on expiration. Imagine how you’d feel at expiration if the stock shot up to $50! This is potentially the biggest drawback of the covered call strategy.

 

Consistent income may not always mean maximum income.

 

You can still take a loss. Opening a covered call position doesn’t protect you from having losses absolutely. It does however help to protect your downside risk although it doesn’t eliminate losses altogether. Your break-even point when writing a call is the amount of the call option you sold subtracted from the stock you paid for each share.

 

In our earlier example, we bought the stock at $30 per share. We then sold calls that were $1.00 each. Our break even in this scenario would be $29. Should the stock close below $29 at expiration, we would suffer a loss on this position.

 

Should the stock drop and you want to sell your position to prevent further losses, you would have to buy your call options back before you can sell any of the shares. Buying back the call options can also cause further losses to your portfolio.

 

Covered calls are expensive. If you don’t already have at least 100 shares of stock in your brokerage account, buying them just for the sake of selling covered calls might not be worth the upfront cost. There are many other strategies that would require less capital. Trading the options outright would require a much lower capital investment while having the potential to create similar income.

 

Income can be small. To execute a good covered call strategy you ideally want a stock that isn’t very volatile and at the very least is trending slowly up or sideways. Without volatility, your options won’t be worth that much when you’re trying to sell them. And if the stock happens to also pay a dividend, the profit from selling the calls can be even smaller.

 

So are covered calls worth it?

 

In short, covered calls can be a profitable strategy if you are aware of the risks involved. Good stock selection is key. Keep in mind there is no risk-free way to invest in stocks other than to never buy any at all. You profit from your ability to manage risk, not by avoiding it.