Covered Call Caution

The benefits asserted for the strategy of selling covered calls sound too good to be true. They are.

From time to time we see articles explaining the benefits of the covered call strategy. They may mention some of the drawbacks, but typically the overall picture is positive. One that ran a while back in the Wall Street Journal reports that covered calls “generate income and can juice returns in any market.” Hey, cut me a slice of that!

If only it were true. In that case no one would hold stock without using this strategy. We would all see better investment returns with lower risk. The world would be a better place. Let’s try to understand the reality.

How it works

call option gives the holder the right to buy shares of stock at a specified price for a limited period of time. If you hold 100 shares of XYZ stock, currently trading at $26.00, you might sell an option giving the buyer the right to buy the shares at a price of $30.00 per share. This is a covered call because you own the shares that would be needed to fulfill your obligation if the option is exercised. The amount you’ll receive for selling the option (called the premium) depends on various factors, including how much time is left until it expires and how volatile the stock is (in other words, how much the price tends to zigzag). Let’s assume you receive $1.75 per share, or $175, for this option. You get to keep this payment regardless of whether the buyer ever exercises the option (uses it to buy your shares).

Three things might happen. First, the stock price might stay about the same. The option won’t be exercised, so you still own the stock and you get to keep the $175, a profit you wouldn’t otherwise have received. Second, the stock price might go up above $30. In this case the option is exercised, so you’re forced to sell the shares, but your profit is even bigger than in the first case, because you still get to keep the $175 option premium and in addition you have the profit from selling the stock. Finally, the stock might decline in value. You have a loss from holding the stock during this period, but it’s at least partially offset by the $175 you received for selling the option.

This might seem like a win-win-win. In the first two scenarios you make a profit, and in the third one you benefit from a partial offset of your loss. Despite this appearance, selling covered calls is a poor strategy for retail investors (that is, people like you and me). It’s highly likely to produce inferior results compared with a conventional investment strategy that involves an equivalent risk level.

Two big problems

There are a number of problems with this strategy, but two are particularly important. The first one relates to risk and return. When you’re using this strategy, the option premium provides only limited cushioning against loss of value in the shares of stock. You’ll still lose a lot of money if the stock price drops sharply. At the same time, you’ve given up much of the upside. If the stock shoots up to $40 the option will be exercised, forcing you to sell the shares at $30. You’ll make a profit, but it will be a fraction of the gain you would have secured if you hadn’t sold the option. And here’s the kicker: it is the opportunity to earn those large gains that makes it worthwhile to take the risk of loss. Selling the option turns a risky investment with large profit potential into one that’s still pretty risky and has only limited profit potential.

To be fair, the Journal article mentioned this concern, citing Jeffrey Cribbs of Chicago Wealth Management, who said, “you’re taking equity risk, but because calls can force you out, you’re not really getting equity returns.” It makes sense that this comment would come from someone in Chicago, where more people understand options.

The other big issue: option trading is expensive. It takes a great deal of skill to get enough benefit from an option strategy to make up for what you lose in trading expenses. Anyone who thinks the only cost is the brokerage commission — that is, anyone who doesn’t understand how the bid-ask spread eats into profits — isn’t sophisticated enough to be using this strategy.

The covered call strategy strategy may be a legitimate tool in the hands of a skilled professional managing a diversified portfolio. For ordinary investors it’s an invitation to inferior results.