Covered Call Risks

Just because you've sold a call against some stock you own does not mean that the stock cannot go down or that you won't lose money. Like any investment strategy, there are risks with covered calls, too.

What you're really doing by selling a call is two things:

  • You are putting a cap on how much you can make (limiting your upside)
  • You are creating some downside protection (reducing risk)

First, a cap on what you can make. By selling a call with a certain strike price, you know that the best you can do is strike price + premium received for the option. For example, if XYZ is trading at $42 and you sell a Feb 45 on it for $3, and then XYZ shoots up to $60 you will only get $48 for your XYZ stock (45 + 3).

Second, reducing risk with some downside protection. By selling the covered call you are reducing your cost in the stock by the amount of premium you receive. If you pay $42 for XYZ and sell a 45 strike call for $3 then you have reduced your cost to $39 ($42 - $3). If the stock closes below 45 on expiration day you keep the stock, your basis is now $39, and you can sell another call for the following month.

Covered call risks are significant and covered calls won't prevent losses.

However, if a stock declines and you have a covered call you will lose less than if you just owned the stock outright (covered call risks are lower than buy and hold risks). If you set the strike price low enough, you can make money with covered calls even if the stock price declines.

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