The most common options-based strategy is called “covered calls” and consists of owning stock long while at the same time shorting call options against that stock. Although it is a very good way to generate consistent monthly income from a portfolio of ETFs and stocks, it is not without risks.
The first risk is an unexpected tax event. Because American style options can be exercised at any time, the seller of the option (i.e. the covered call writer) has a risk that the buyer will exercise the option before expiration. Normally it doesn’t make any sense for the buyer to do this if there is still time premium remaining in the option, because the buyer gives up the time premium when he exercises. So if he wants to close out his option that still has time premium then he is better off just selling the option instead of exercising it.
However, there are some crazy people in the market and occasionally the covered call writer receives an assignment that doesn’t make financial sense. The risk is that the call writer ends up having stock called away which creates a tax event from the sale (clearly, if the covered call is in a non-taxable account like an IRA then it’s a non-issue; you can just go buy more stock to replace the shares that were called away). Sometimes option holders will do this the day before an ex-dividend date if there is only a little bit of time premium remaining in their option so that they can capture the dividend.
The next risk is the reduced upside potential above the strike price. The covered call writer can set the strike price to any value he likes, but one thing is true — whatever value he sets it to is the most he will receive for his stock between today and expiration. If there is a positive 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.
Covered calls do not prevent losses. Some investors feel a sense of insurance because of the call premium they received when they sold the call. However, the premium won’t be enough to protect against losses if the stock drops below the net debit of the covered call trade (stock price paid less the option premium received). While there is some downside protection in a covered call position, it is not unlimited. Stocks can drop dramatically in a short period of time. In this case the covered call writer will lose less than the buy and hold investor, but it may still be a loss nonetheless.
And then we come to yield chasing. It is very tempting to use a covered call screener to find the high yield covered calls and then start writing them. But the screener is just the 1st step in any covered call program. After you get a list of candidate trades from the covered call screener you then must do additional research to understand why those premiums are so high. You can make a great return with covered calls but like any other investment strategy you must be prudent and proceed with carefully researched caution.
To see more option trading tips take a look at this fascinating article.
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