Q: I've been learning about options and am thinking about writing covered calls against some of the stocks in my portfolio. It seems like this is a pretty risk-free way to generate income -- what's the catch?
First off, for those who aren't familiar, a covered call essentially means that you sell someone else the right to buy a stock you own. As an example, if Company X trades for $65 per share and you own 100 shares, you might sell a call option that allows another investor to buy your shares at $70 each anytime within the next two months. In exchange for selling this right, you receive a payment.
It's true that covered calls are a risk-free income strategy in the sense that once you sell the contract, the payment you receive is your to keep, no matter what happens.
To understand the downside, consider the three things that can happen after you sell the covered call:
First, the stock could go down, in which case the option expires worthless. You keep the premium and your loss is less than it otherwise would have been.
Second, the stock could go up, but remain below the contract price (called the "strike" price). The option expires worthless, your stock is worth more, and you get to keep the money you collected for selling the option.
Third, the stock could rise to a price greater than the strike price before expiration. You still keep the option income, but you're now forced to sell your shares for less than the current market value. This is the potential drawback of selling covered calls against your stocks.
In a nutshell, covered calls can be a great income strategy, but they're not a free lunch. You're essentially giving up some of your upside potential in exchange for income. This can still be a desirable arrangement for some investors, especially if income is your priority, but it's important to be aware of what happens if your stock jumps higher.