Covered Call Writing: What Are the Main Risks When Using this Covered Call Strategy

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Covered call writing is an investing technique which has been gaining in popularity over the past few years. By following a few recommended guidelines an investor is able to generate consistent monthly income from his or her equity portfolio. While this technique works best in neutral or even slightly increasing markets, an intelligent investor can learn to make money in almost any type of market. As with any investment strategy, however, selling covered calls is not without risk.

Writing Covered Calls - The Basics

Selling a call simply means that you have sold the right, but not the obligation, to buy your stock at a certain price, known as the strike price, on or before a certain date, known as the expiration date. A covered calls means that the investor who is selling the call actually owns enough of the underlying shares of stock so that if he or she were called out, they would not need to go into the market and buy the stock in order to satisfy their obligation. For every call that an investor wishes to sell, he should own one hundred shares of that stock. If for example, an investor wants to sell 5 calls he or she must own 500 shares in order to be covered.

Most people that sell covered calls are using this technique to supplement their monthly income. Covered calls provide a source of cash flow to the investor since they are paid a premium when they sell the call. This premium is theirs to keep regardless of what happens to the share price subsequent to the transaction. While this may seem like a no-lose situation, there are a few risks associated with writing covered calls.

Risk Associated with Selling Covered Calls

Perhaps the most significant risk associated with selling covered calls is actually opportunity risks. When you sell the call against your equity positions you are effectively capping the amount of income you can make on this particular trade. If the stock explodes through the strike price you will miss out on a lot of capital appreciation.

Undisciplined investors may try and chase this appreciation by repurchasing the call, at a much higher position, and then either selling a higher valued call or selling the stock completely. In most cases this does not work as the investor hopes. Often the investor will repurchase the calls at a higher price only to see the stock price settle back down to a normal trading range. Unless the investor happened to take advantage of the situation quickly they most likely would have simply turned a winning position into a losing position.

A second significant risk associated with covered call writing occurs if the stock rapidly decreasing in value. Small, and sometimes even moderate, decreases are easily managed. Significant decreases reduce the likelihood of exiting the trade profitably. Seasoned covered call writers will sometimes set stop-losses on their stock positions. Once the value of the stock falls through a certain price level, the broker, or automated software, will automatically execute a sale of your stock which can leave you 'naked'.

In addition to exposing you to unnecessary risk, many times a brokerage account does not allow call positions to be uncovered. If this is true for your account, you will not be able to set automatic sell positions and will be forced to monitor your positions manually.