Problems with Covered Calls

Problem - Solution

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 risk, high capital, missing capital gains, taxes, and management.

It is my belief that the benefits far outweigh the problems with covered calls for income investors.

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.

The Biggest Problem with Covered Calls is Market Risk

The biggest problem with covered calls is that basic covered call strategies don’t work during bear markets. While there are many more bull market years than bear market years, bear markets are a fact of life for stock investors.

But this is an excellent point to counter this problem with covered calls.

Stock investors are subject to stock market risk anyway! This is why covered calls make sense for investors who are already subject to stock market risk.

Granted, it may take shifting out of some stocks or funds to get started selling covered calls, but this is very doable.

And while there are some advanced covered call strategies that work in bear markets to at least avoid some of these challenges, 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. 

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.

This is because the amount of their net worth that they want to allocate to stocks can be tied up in positions that have dropped due to the overall bear market.

Let’s say a covered call investor decides to allocate a total of $500,000 into stocks for covered call strategies. After a few months of selling covered calls, the investor has bought stocks with the entire $500,000.

Then a bear market hits taking the stock market down 45% over the next year. Since the call writer’s stocks would have almost certainly dropped in value, too, it will be hard for her to sell call options with strike near her cost.

Click here to ready my related post entitled How Many Income Streams Should You Have?

There are a few ways to lessen this problem with covered calls, if not avoid it entirely, as explained in the next section.

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 increase cash (money market) or Treasury bond holdings to lower risk.

Then this investment money can be switched into stocks after valuations have become cheap again. But in the meantime, getting income from basic covered call strategies in the way down would be hard.

Click here to read my post on cash portfolio in a allocation.

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.

Sell Covered Calls on Dividend Stocks

Another way to overcome some of the income that is lost when covered calls can’t be sold against existing positions 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 covered call income, it will reduce the risk, too. Think of buying a put as insurance, which is never free.

There are other more complex option strategies that can be used, but simple strategies suit my personality better.

My husband, Larry, on the other hand, teaches the most 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.

Click here to see a covered call example I did on a dividend stock.

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 and falling earnings can all cause the price of a stock to drop, or even lead to bankruptcy.

It can be tempting to sell covered calls on companies with high risk because the tempting option premium can be in the 4% a month range.

While deep in the money covered call strategies can work well for higher risk companies, the risk is still there for the underlying stock to tank.

This all goes back to creating an overall wealth plan with clearly defined risk as it relates to your investment goals and investing within those higher level choices.

Again, this problem with covered call strategies relates to all stock investors, not just covered call writers.

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 and small business.

This high level of capital is a disadvantage for covered call writing, but this is true 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.

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, and it may not even happen.

But 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.

Click here to read my post How to Create a Wealth Plan.

Taxes

The income from selling call options is short term. As such, it may be taxed at your highest tax rate.

Note that covered calls can be sold inside an IRA. The only problem is that the covered call income is stuck inside your IRA.

If you’re subject to a Required Minimum Distribution on a regular IRA, income from covered calls can be part of what you withdraw.

Taxes are very unique to each individual, and rules can often, so be sure to check with your CPA. But I do want to include taxes as a common problem with covered call strategies 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.

For this reason, covered call strategies can be an excellent way to increase income from stocks without increasing risk.

Wealth Building Strategies eBookCovered calls are one of our top 9 income producing wealth building strategies covered in my eBook. Click here to download a copy if you want it. 

 

 

 

Disclaimer – Nothing in this post or anywhere on this website is meant to be construed as personal financial advice. You are responsible for your own money. 

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