Covered Call Risks And Opportunities

Category : Penny Stocks

Although covered calls seem to have low risk, it is possible to get into trouble if you don't pay attention to the risks that do exist. You may do quite well for several months and then find yourself having a really bad month because you ignored or forgot to research some of the risks.

The first risk is an unexpected tax event. Because U.S. style options can be exercised at any time prior to expiration, the seller of the option (i.e. the covered call writer) has a risk that the buyer will exercise the option prior to expiration. Normally it doesn't make economic sense for the buyer to do this if there is still time premium remaining in the option, because the buyer forfeits the time premium when he exercises. So if he wants to close out his option that still has time premium then he would be better off just selling the option instead of exercising it.

Hard to believe but there are some uninformed actors involved in the stock market. They do crazy things like take early exercise on options that have time premium (whereas it would make more financial sense for them to just sell the option so they didn't have to forfeit the time premium). Now, if this happens in an IRA account it doesn't matter (since it's a non-taxable account). But in a taxable account it can cause tax problems. Usually you only have to really look out for this as an ex-dividend date gets near, and only then in options that have just a penny or two of time premium.

Next risk is the reduced upside potential above the strike price. The covered call writer can set the strike price to whatever value he likes, but one thing is true -- whatever value he sets it to is the most he will receive for his stock between now and expiration. If there is a happy surprise of any kind (M&A takeover, increased guidance, earnings beat, competitor fails, etc) and the stock rises above the strike price then the covered call writer will not make as much as he could have made if he hadn't sold the call.

Downside protection is comforting, but should not be leaned on as a savior to prevent all losses. The option premium you receive will cushion the first part of any loss but if the stock drops significantly then you will probably still have a loss (less than a buy and hold investor, for sure, but it's still a loss). Often cited as the tradeoff for putting a cap on your upside potential, it is definitely a good feature of the strategy but just be aware that you can still lose money with covered calls.

Lastly is the risk of chasing yield. It's tempting to use a covered call scanner to identify the highest yielding covered calls and then just blindly write those options. Seldom a good idea. A covered call scanner is just a starting point for additional research. It will help you identify juicy premiums as an idea list to start from but then the you need to thoroughly research each one before investing. Covered calls have risks but they are one of the most conservative investments an investor can make, if used correctly.

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