Covered calls can be an excellent way to increase income from stocks but like all investments, covered calls aren’t perfect.
The problems with covered calls include stock market risk, company specific risk, high required capital, forfeiting of potential capital gains, taxes on call income, and ongoing management of unexercised options.
It is my belief, however, that the benefits far outweigh the problems with covered calls for income investors that want to own stocks or stock ETFs (Exchange Traded Funds) anyway.
After selling hundreds of covered calls over the past 13 years, I’ll share some solutions to avoid problems with covered calls that I have learned firsthand over the years, sometimes the hard way.
Relying on Covered Call Income
One of the biggest problems with covered call strategies happens when investors come to rely on covered call income as their main source of income and a bear market occurs.
The reality is that basic covered calls don’t work during the occasional bear markets.
Also, the amount of net worth allocated to stocks can be tied up in positions that have dropped in price due to an overall bear market.
Let’s say a covered call investor decides to allocate a total of $200,000 into stocks for covered call strategies. After a few months of selling covered calls successfully every month, the investor buys more stocks with the $200,000. The plan is to sell covered calls for the month with these stocks as the underlying positions.
That month, most of the call options don’t get exercised because the stock market begins an overall decline. This leaves the investor with stocks that cost $200,000 which are declining in value. He can’t sell covered calls with at the money strikes against these stocks, though, because if the calls get exercised, he will be forced to sell the stocks at a loss.
The stocks continue to decline, and a bear market ensues taking the stock market down even more.
Since the call writer’s stocks dropped in value, too, his capital is tied up in stocks with losses against which he cannot sell call options.
Click here to read my related post entitled How Many Income Streams Should You Have?
As you may have read here, income diversification is important to provide ongoing income when one income source is lost, even if it’s temporary as would be the case with covered calls.
The Biggest Problem with Covered Calls is Market Risk
The biggest problem with covered calls is stock market risk.
While there are many more bull market years than bear market years, bear markets are a fact of life for stock investors.
Almost all investors own stocks, however, and are subject to stock market risk anyway. This is why covered calls can make sense for investors who already are exposed to stock market risk.
Granted, it may take shifting out of some stocks or funds to get started selling covered calls for most investors, but this is very doable.
And while there are some advanced covered call strategies that work in bear markets, it’s much easier to sell covered calls during bull markets.
You can read my related post entitled How to Know If the Stock Market Will Go Up or Down here.
There are a few ways to lessen bear market risk as it relates to covered calls, if not avoid it entirely, as explained below with 4 solutions.
Reduce Stock Market Risk as Markets Get Overvalued
One way to lessen the probability of this problem is to reduce stock market risk as stocks become overvalued.
Investors can by this by increasing cash (money market) or Treasury bond holdings to lower risk. Note that nn investor could even sell call options against a bond ETF in this case.
Investment money could be switched back into stocks or stock ETFs after stock prices have become cheap again. Click here to read my post on cash portfolio in a allocation.
Sell Covered Calls on Dividend Stocks
One way to overcome some of the income that is lost when covered calls can’t be sold during bear markets is to sell call options on dividend stocks.
This allows an investor to make up at least a little of the lost income during bear markets.
While dividend income of 4% or 5% is hard to get excited about when an investor is accustomed to income from covered call strategies of 12% to 18% a year, dividend income is certainly better than no income at all from stocks.
I write more about selling covered calls on dividend stocks in my post How Much Do I Need to Invest to Make $10,000 a Month?
Covered Call Strategies for Overvalued Markets
One of the best covered call strategies to protect investors from bear markets is accomplished by purchasing puts on covered call stock holdings.
Here’s why this works: The value of the put should increase when the underlying stock drops. And the call you sold will decrease in value as the stock drops allowing the option to expire worthless or giving a covered call investor the option to buy back the call option.
While buying a put will reduce overall income from a covered call, it will reduce the risk, too. Think of buying a put as insurance, which is never free. Also, the income from the call option pays for the cost of the put when structured properly.
There are other more complex option strategies that can be used to generate option income, but simple strategies suit my investing personality better. My husband, Larry, on the other hand, teaches more advanced option strategies after being a professional trader for over 30 years.
Selling Covered calls on Undervalued Securities
When the overall stock market is expensive, I seek out undervalued stocks for covered call strategies.
While these stocks will probably drop during a bear market, since they are already undervalued, they tend to fall softer than high flying growth stocks.
Those are 4 good strategies to reduce one of the main problems with covered calls, bear markets.
Next, let’s look at a few more problems with covered calls.
Covered Call Problems Related to Company Risk
The company issuing the stock against which the calls are written can drop significantly if the company runs into trouble. Scandals, management problems, redundancy, politics, and falling earnings can all cause the price of a stock to decline, or even lead to bankruptcy.
It can be tempting to sell covered calls on companies with high risk because the generous option premium can be in the 4% a month range in these situations. While deep in the money covered call strategies can work well for higher risk companies, the risk is higher for the underlying stock to tank.
One way to avoid company specific risk is to invest in index based funds. Many index based ETF’s are ideal for covered call strategies. I explain a covered call strategy with ETFs I did after the last bear market in the video below.
Selling Covered Calls Requires High Capital
Investing in stocks for selling covered calls requires a high level of capital, unlike some other investment strategies such as real estate or buying a small online business.
This high level of capital is a disadvantage for covered call writing, but high capital is required for all stock investors.
And by adding covered call income to stock ownership, investors are leveraging their stock investments by adding another income stream to their holdings.
When stock investors can get capital gains, dividend income, and covered call income from a single stock, they are optimizing its return potential. I refer to such strategies as Multi Wealth Builders as I explain in my video below.
Note that like most problems with covered call strategies, this problem is common to all stock investors. Selling a call option against stock holding actually helps investors overcome the issue of limited income from a high capital investment.
Capital Gains Are a Problem with Covered Call Strategies
The biggest problem with covered call strategies for many investors is that capital gains are lost from selling calls against stock positions.
Let’s use an example of a covered call investor buying a stock for $50 and selling a call option with a strike price of $55.
If the stock rises to $60 by option expiration, the investor will have to sell the stock for $55 missing out on the stock movement from $55 to $60 for a capital gain.
This is clearly a problem with covered call strategies, but there are ways to work around this problem as I explain in my post Are Covered Calls a Good Strategy?
Plus, capital gains are not a sure thing since the stock may not rise after purchase while the income from selling a call option is a sure thing.
(My post How to Evaluate an Investment with has more on capital gains vs income.)
Everything with investing is a trade off. In this case, covered call sellers trade capital gains potential for income.
When I place a covered call trade, I ask myself if I will be happy with the income I am getting even if the stock soars.
If the answer is no, I don’t place the trade. If the answer is yes, I sell the call option.
Frequently, the covered call income is 3% over a 4 to 6 week period. This would be a very high capital gain for a stock over 4 to 6 weeks, and it may not even happen. Yet I know for sure if I call the call option the funds will go right into my brokerage account.
Investors should begin by clarifying their investment goals in an overall wealth plan defining if they need capital gains or income to become financially independent. This will guide an investor as to whether covered calls are a good choice in the first place. Click here to read my post How to Create a Wealth Plan.
Taxes
High taxes can be a problem for covered call writers. Let me expand on this while explaining that you should check with your CPA about taxes.
The income from selling call options is short term. As such, the income will normally be taxed at your highest tax rate if covered calls are sold inside a regular account.
Note that covered calls can be sold inside an IRA. The only problem is that the covered call income is stuck inside your IRA when this is done.
If you’re subject to a Required Minimum Distribution on an IRA, income from covered calls can be part of what you withdraw.
Taxes are very unique to each individual, and rules can often, so, again, be sure to check with your CPA.
I do want to include taxes as a common problem with covered call strategies, however, due to the short term gain from selling the call options.
Management Can Be a Problem with Covered Calls
There’s no doubt that selling covered calls takes more time and attention than passive stock investing in an index based fund.
When covered call positions don’t get exercised, this leads to more management.
I have found that given the high covered call income over and above stock dividends for slightly lower risk, it’s worth the time needed. And in comparison, to other forms of income, covered call income is relatively passive.
Summary of Problems with Covered Call Strategies
Like all investments, there are some problems with covered calls. As you can see, most of the problems with covered calls are present for all stock investors, not just those who sell covered calls. For this reason, covered call strategies can be an excellent way to increase income from stocks without increasing risk despite the problems.
The best place to start is with my Ultimate Wealth Plan. You can get it here now.
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