Stay Away From Covered Calls

You won't find a simpler strategy than buying and holding quality stocks. But no matter how well something works, you'll always find someone trying to squeeze a little extra out of it.

One example of this is an options strategy known as the covered call strategy. Although this strategy can generate a small amount of additional income from a buy-and-hold portfolio, it comes with risks that many of the brokers and financial advisors who recommend the strategy fail to make clear for their clients.

How it works
Although options are somewhat complicated -- Fool Jim Gillies took a series of articles to explain their basics -- the idea behind them is relatively straightforward. To use the covered call strategy, you have to own shares of a company that also has listed options available for trading. For every 100 shares you own, the strategy has you sell one call option with an expiration date at some time in the future. Usually, the price you choose at which the option will be exercised -- also known as the strike price -- is above the current market price of the stock.

Here's an example. Say you own 1,000 shares of Microsoft (Nasdaq: MSFT  ) . It currently trades at around $29.50. Your broker might recommend that you write call options that give someone else the right to buy your shares from you for $32.50 per share, anytime between now and the middle of October. At current prices, you'd get paid about $400 for these options -- essentially quadrupling the regular quarterly dividend on your stock.

As long as Microsoft doesn't go above $32.50 before October, that $400 is yours to keep. Looking at the stock's price history, Microsoft has bounced between $22 and $31 for the past five years. What that means is that if you'd used the covered call strategy repeatedly over time, you'd have earned a lot more income in addition to the dividends you got along the way.

Penny-wise, pound-foolish
Skeptical readers will point out that this strategy creates commissions for brokers each time you sell call options. But that isn't the worst thing about covered calls. The main problem with the covered call strategy is that it flies in the face of why you own stocks in the first place. While dividend income can be an important factor in choosing a stock for the long run, a big part of how stocks add value to your portfolio over time is through price appreciation. By using the covered call strategy, you essentially give away your right to future price appreciation above a certain point -- which can be a disastrous mistake in many cases.

To see how covered calls can go awry, look at another example. During most of 2004 and 2005, shares of Reliance Steel (NYSE: RS  ) were stuck around $20. If you'd used covered calls with a strike price of $25 during that period, you would have earned a lot of additional income. The problem is that when the share price started to rise in the fall of 2005, your calls would have been exercised -- which means that you would have been forced to sell your stock. Granted, you would have turned a nice quick profit, as you'd get paid $25 for shares that had recently traded for $20. But you would have given up all the future gains in the stock. With shares currently trading above $60, your easy $5 profit would have cost you a 3-bagger.

In addition, simply buying and holding your stock lets you decide when you're going to pay tax on any capital gains. As long as you don't sell, you won't get a tax bill. However, if you're forced to sell your shares under the covered call strategy, Uncle Sam will want his share next April. Even worse, if you use covered calls with newly acquired stocks, you might end up with short-term capital gains, which don't qualify for lower tax rates and can more than double the taxes you'd otherwise have to pay.

Hindsight is 20/20
Experts counter that they recommend covered calls only for stocks that trade in fairly tight price ranges. However, stocks can always break out of established trading ranges. Furthermore, with so many stocks with potential for huge price appreciation, keeping a stock specifically because you don't expect it to rise dramatically in price seems silly.

While the income from covered calls may appeal to conservative investors, it's often not worth what you give up. The potential for lost profits, additional taxes, and constant fees makes the covered call strategy questionable for most investors.

For related articles:

If you need income from your portfolio, don't resort to gimmicks -- choose stocks that will give you the income you need. The Motley Fool's Income Investor newsletter highlights ways that investors can do that without sacrificing capital appreciation. See how Income Investor can put more money in your pocket today with a 30-day free trial.

Fool contributor Dan Caplinger has written covered calls from time to time, but he usually ends up disappointed. He doesn't own shares of the companies mentioned in this article. Microsoft is an Inside Value recommendation. The Fool's disclosure policy isn't optional.


Read/Post Comments (18) | Recommend This Article (36)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 18, 2008, at 1:03 AM, JFrazer1 wrote:

    I think this article deserves a relook considering the current market conditions. Personally, I do use covered calls. I generally sell them for only 1 month at a time, and only to finance the purchase of puts on the stock. I generally will write them with strikes about 10-20% above the current value. If I'm forced to sell at 10-20% profit in one month I'm not going to cry about it. I use the money to buy puts that have strikes above my cost basis for the equity, so i'm basically risk free. I use the left over profit to buy additional shares of the stock. That way, even if the calls are exercised I still benefit from the additional stock I purchased, and It doesn't even have to rise as much because I lowered my cost basis by selling the call. Also, it does not have to be all or none. You can sell calls on half your position, or less, or more.

  • Report this Comment On September 24, 2008, at 11:04 PM, cgmario wrote:

    With the volatility in this bear market these days it would be "foolish" not to hedge. I started using covered calls when I lost $1500 USD with CEMEX, one of the FOOLS top recomendations !!!

    I prefer a 5 to 10 % monthly income than losing 10% in one week.

    Thanks for your recommendations fools, I was really the fool for following them.

  • Report this Comment On November 02, 2008, at 9:21 PM, thebcinvestor wrote:

    Over the years, there have been other similar commentaries on cc strategies. I never tell others how to invest their hard-earned money. I simply relate how I invest mine. Bottom line....I respect other points of view and then do what works for me based on my own decisions. That being said, consider these points:

    1- The article is based on a buy-and-hold portfolio. My portfolio turns over 20-80% each month based on my system criteria. If we had purchased GM (one of our country's greatest blue-chip companies) in 1953, we would actually be losing money 55 years later. So much for buy-and-hold portfolios.

    2- It references selling predominantly out-of-the-money strike prices. This is way too limiting an approach as market conditions and technical analysis may CRY for selling an in-the-money strikes.

    3- It speaks to paying excessive commissions. For the educated investor who knows what he or she is doing, a discount-online broker will suffice. I pay $5.95 per trade (slightly more for options). Commissions are a NON-EVENT. Next....

    4- It talks about giving up price appreciation... the first valid point. But this is the only major disadvantage of this strategy and, in my view, the positives far outweigh the one negative.

    5- Regarding the Reliance example: Your calls would be exercised only if you allow this to happen. If you choose not to allow assignment, simply buy-back the option and you will still own the stock. It is possible for assignment to occur before the expiration date. This is rare but should it happen, you can simply buy back the shares (if it makes sense to do so) or use the cash for another stock. Smart investors never fall in love with a stock, just the deal.

    6- Regarding taxes: I currently do my cc trading in sheltered accounts....no tax consequences at this time. If you need the cash right away, be happy to pay the tax for profits hard to generate with other strategies.

    7- If an expert recommends only stocks that they don't expect to rise dramatically for this strategy, the term "expert" should be forever expunged from their resume. If you buy a stock @ $58 and sell the $60 call, and you earn a 1-month return of 6%, who cares if the stock went to $65. I'm happy with the 6%. How would you feel?

    To sum up, I suggest investors never follow the edict of one person and that includes me. This is an example of an article that comes to a strong conclusion without considering other critical elements. There are several other more esoteric factors that I haven't even mentioned in this commentary. I have every confidence that by paper-trading the cc strategy, you will come to the right decision for your investment future.

  • Report this Comment On November 25, 2008, at 8:58 AM, CrawlingUpward wrote:

    If your stock does go "in the money", you can always buy back the option you've sold, and sell another option for the next month, at the same strike price. In this case, no sale of the stock would be necessary, and you'd still continue to make income.

    I have an options strategy where I only open covered call positions with in-ther-money calls. It generates approximately 3% a month on the good months, and I've done fairly well throughout this bear market.

  • Report this Comment On December 15, 2008, at 3:49 AM, Ratabulum wrote:

    The other frequently overlooked issue is the value of the monthly return. If you write a call that is 5% OTM (ie. 105 strike on a $100 stock) and the premium itself is worth 5% or $5, the underlying stock has to rise by more than 10% each month in order to justify holding the stock long only. www.optionistics.com will give you a nice option premium screener. Generally speaking, if you're writing ATM options, the premium must be greater than 3% or else you're just tracking the stock.

  • Report this Comment On December 22, 2008, at 3:11 AM, mamerten wrote:

    As a long term covered call trader, I can see some of the author's points, but disagree overall.

    The covered call trader has to be fully aware of the potential drawbacks. One way to be aware of this is to use a tool to assist you when to manipulate an open position at www.coveredcallcalculator.net. In a bear or sideways market, a covered call strategy will outperform stocks, but in a strong bull market it will not. Just be prepared.

  • Report this Comment On December 23, 2008, at 8:30 AM, phos wrote:

    It's ironic that the author's example for buy and hold long-term is now at 18 dollars a share. So, it seems that most of the article is wrong. Of course, it is a well known fact that the covered call strategy is far superior to a buy-and-hold strategy in a beat market (see http://www.cboe.com/micro/bxm/introduction.aspx), so I'm not saying anything profound. I am, however, a fan of the covered call strategy. I have been for 7+ years. Especially right now, with options premiums so freaking high!

  • Report this Comment On January 13, 2009, at 9:58 AM, mvp019a wrote:

    Terrible article; does not give the whole story and strategies that you can use around the covered call scenario depending on what is happening to the calls. As one poster said, you don't have to put your entire position up (just as one small example.) Incredibly short-sighted article that is the typical "options are terrible" gibberish.

  • Report this Comment On January 13, 2009, at 10:04 AM, mvp019a wrote:

    And to add; the risk in CC writing is NOT that the stock will go up past your strike price and you "lose" profit you "could have" had...that's just hindsight greed. You (hopefully) wrote the call at a price you thought would be fair if they took the stock away...anything else smacks of "market timing" which will get you screwed every time. The actual risk is that the stock goes DOWN while you are "locked" into holding it, but even then, you can sell the stock if it hits your stop loss, and buy the call back (for which the premium should be a fair bit lower than when you sold it.)

  • Report this Comment On April 27, 2009, at 1:05 PM, thebcinvestor wrote:

    Some great comments about this article. CC Writing is a wonderful strategy but it's not for everyone. There is a learning curve and some time commitment. But, if you make these commitments the rewards are well worth it.

    I particularly like the flexibility you have after establsihing your stock/option position. Your already impressive returns can be enhanced even more through the utilization of mid-cycle and expiration Friday exit strategies.

    If you're new to this strategy, educate yourself and paper trade for a few months. The advantages and low risk factors will soon become apparent.

  • Report this Comment On May 13, 2009, at 12:38 PM, Iluvitar wrote:

    The comments on this article are far better than the article itself. In regards to the article’s point that “While dividend income can be an important factor in choosing a stock for the long run, a big part of how stocks add value to your portfolio over time is through price appreciation.” It is obvious that the author has not studied the effect of dividend reinvestment in increasing a portfolios value. I read an article in the Journal of Portfolio Management, that calculated that the value of the DOW if some one reinvested all dividends would be above 900,000 points! So much for the hold for appreciation approach. The real risk in covered call writing is a sharp decline in the underling security, in which case have to but also have to by back your option in order to sell the losing stock.

    In today's market I wouldn’t write on a stock/call combination that is not returning at least 30-40% annualized if called. I hope all of my buy/writes are called out now and forever.

  • Report this Comment On July 18, 2009, at 8:28 AM, rainmon wrote:

    yes there are a couple down sides to cc's but still the best way to get a safe return in a bad market and a great way to get a good return in a flat market. The only problem I have is there does not seem to be a way to auto buy back on the option to then set a stop loss sell order on the stock.

  • Report this Comment On October 23, 2010, at 12:31 AM, scanlin wrote:

    There is a good covered call screener at http://www.borntosell.com

    They also have a free covered call newsletter, tutorial and blog.

  • Report this Comment On June 25, 2011, at 5:19 PM, rmatzen wrote:

    This article is extremely simplified in its explanation, but I agree with the final conclusion, especially in this market

    http://www.suite101.com/content/why-covered-calls-may-save-y...

  • Report this Comment On December 03, 2011, at 1:35 PM, TacticalOptions wrote:

    Pretty good article overall, it does a good job outlining some of the risks. However, one strategy that is doesn't mention is call writing on broad based index ETF's, which lowers some of the risks that individual stocks contain, like exploding to the upside due to a takeover or strong earnings report.Calls can also be rolled for a credit to higher strikes to prevent assignment sometimes.

    http://sellacalloption.com/

  • Report this Comment On August 17, 2012, at 9:39 PM, haysdb wrote:

    I'm brand new to covered call writing - just wrote my first one yesterday, and yet several things about this article struck me as someone just making up scary sounding reasons why covered calls are bad.

    1. I'm writing covered calls in my IRA account. No capital gains issues.

    2. Disastrous? Seriously? If my stock appreciates 10% in the next month and my stock is called away, how is that a disaster? What, because I could have made 15%?

    3. Why not just buy to close, or if it gets called away, buy it back? Only if the price is higher than the strike plus the premium you received will you actually "lose" anything. Right?

    4. $8 commissions add up, but they aren't going to kill me. It's not like I'm selling one call for $20.

  • Report this Comment On February 21, 2013, at 2:41 PM, 47Gary wrote:

    it's always odd to join the discussion 6 months later but I agree with haysdb and would add that the reason I joined MF is to find 'solid' stocks (recommended) in which to invest and they have come through very well for me - I buy them in 100 share units and sell covered calls simultaneously and have done as haysdb said, buy to close or let them be assigned for a significant annualized return depending on the circumstance;

    I respect Dan's comments but the issue remains an empirical one, how do buy/write trades of MF recommended stocks perform? my limited sample says it performs very, very well

  • Report this Comment On July 17, 2013, at 2:09 PM, etbob1 wrote:

    The author obviously does not relate positively to the basic strategy involved in writing covered calls, i.e., generating steady monthly income vs. being able to pick the 1 in a 100 stock that will triple in price in a year.

    P.S.

    If you were truly that good at picking stocks, you would be the richest person in the world in a few short years, and would probably not spend your time writing articles like this one!

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