Pros and Cons of Using Covered Calls in Modern Investment Strategies

A covered call is a risk management and an options strategy that involves holding a long position in the underlying asset, such as a stock, while simultaneously selling a call option on the same or a related stock. This strategy is traditionally employed by investors who expect the underlying asset to experience minimal price movements.

Pros of Selling Covered Calls

The main advantage of selling covered calls is income generation. By selling the covered call, the seller receives an immediate premium from the transaction. This premium can be substantial and can help offset potential losses if the stock price drops. Additionally, if the covered call is exercised, the investor profits from both the premium and the capital appreciation from the sale of the stock.

Example

Consider a stock, XYZ, trading at $52 per share. A call option with a strike price of $55 expiring in one month is priced at $3. To initiate a covered call on XYZ stock, an investor buys 100 shares of XYZ and sells a call option obligating them to sell XYZ at $55 if exercised by the option buyer. If the stock price remains below $55 at expiration, the investor keeps the 100 shares and the $300 premium. If the stock price is above $55, the call option is exercised, and the investor sells the 100 shares at $55, resulting in a total profit of $600, including the $300 premium and the $300 in capital appreciation.

Offsetting Downward Moves

If the stock price falls, the premium received helps offset the loss. For instance, if the stock price drops to $49 at expiration, the investor can sell their shares for $49, resulting in a loss of $3 per share. However, this loss is offset by the $3 premium received, resulting in no net loss.

Cons of Selling Covered Calls

The primary downside of covered calls is limitation of upside potential. The seller cannot enjoy the full appreciation of the stock if it rises significantly above the strike price. The investor's profit is capped at the premium received plus the difference between the stock's purchase price and the option's strike price.

Hurdles in Execution

Additionally, there are practical challenges in executing a covered call strategy, including the need for sufficient capital and the potential for volatile markets. High volatility can result in the option strike going in the money, requiring additional capital to hold the position until expiration. This can be particularly challenging due to new regulatory restrictions and market conditions that make it difficult to roll over strikes.

Risk Management

Another con is that the premium amounts are based on the historical volatility of the underlying stock. Highly volatile stocks may have lower premiums, increasing the risk of large price fluctuations. Furthermore, significant drops in the stock price, even those greater than the premium received, will result in a net loss.

Final Thoughts

Overall, the covered call strategy is a double-edged sword. While it offers a steady stream of income and some protection against downward movements, it limits the upside potential and can be complex to manage. Understanding the nuances of this strategy is crucial for investors aiming to incorporate it into their investment portfolio.

Key Takeaways:

Income generation through immediate premium receipt Limitation of potential upside gains Practical hurdles due to new regulatory restrictions and market volatility Hedging against downward price movements