Covered Call Writing: Some Traps to Consider

Covered Call Writing is regarded as a gentle way to capture option premiums with limited risk. It is often described as a way of increasing overall return on shares owned by the investor - rather like renting your shares out.

The strategy involves selling a call short against a long position held in the underlying asset. Therefore the risk to the short call position is 'covered' by being long the stock.

For a more detailed overview of covered calls please click here

For a practical example of writing a covered call please click here

It is argued that an investor should never purchase stock solely to enter the 'options writing business . Stocks should be able to hold their own in a portfolio regardless of whether covered calls are sold, instead of being there just because options premiums on the stock are attractive.

In saying this, there can be good returns available, especially if the shares are purchased on margin. It is big business in Australia and does carry a risk if the underlying share price falls. This all important and a big fall can instantly negate any profits and if on margin, can result in a margin call. The GFC bared all about this problem.

Additionally writing calls options is not a substitute for buying put options as the premium received is usually only a fraction of the share price.

Therefore, Covered Call writing should be viewed in its correct context. On stocks that move up or are stable it should improve returns. 

In theory, covered call writing sounds perfect, but there are 'limited risks' or in layman's terms, pitfalls and downsides that an investor should be aware of in advance of writing covered calls (selling the option).

• Covered calls are best written on stocks are trading in a range, such as a channel. Therefore your underlying long stock position is less likely to be exercised. Couple this with the contradictory aspect of volatility (demonstrated by Bollinger bands) that makes the premiums more attractive to the seller.
  

• The call option premium is usually too low to be attractive to sell if a stock is trading sideways and volatility is low. For example, why would you want to limit the growth potential of stock that you hold if the only option you could sell would be less than the potential gains in the stock price. In a worse case scenario if the share price falls the small premium you received for the call option sale is not much of a cushion, and brokerage costs in exiting the call options can further add to the loss.
  

• Conversely, a very volatile underlying stock will have a high premium on the options. The downside is that if the share price increases there is a likelihood that you may get exercised.
  1. Before that happens, will you exit the whole trade before expiration?
  2. Would the option premium decayed enough to leave you with some profit, or has the volatility increased so you have to buy back the short option at even more of a loss than the intrinsic value?.
  3. If you wait until expiration your money is tied up in a dead-end trade where there is little upside. Do you take a loss on the short call option, hold onto the stock, and hope the stock keeps going higher?
  4. Where do you put a stop on the underlying stock if it starts to decline, especially below your breakeven point?