Are Covered Calls Too Good to Be True? A Comprehensive Analysis
In the realm of options trading, covered calls have emerged as a popular strategy. This strategy involves holding a long position in a stock and selling call options on that same stock. While it offers several advantages, it is crucial to understand its limitations and risks.
The Advantages of Covered Calls
1. Income Generation
Selling call options generates premium income, which can enhance the overall return on the stock position.
2. Downside Protection
The premium received from selling the call provides a small buffer against potential losses in the underlying stock.
3. Lower Volatility
This strategy can reduce the volatility of your overall portfolio, making it a conservative approach compared to outright stock ownership.
The Disadvantages of Covered Calls
1. Limited Upside Potential
If the stock price rises above the strike price of the sold call, your gains are capped at that strike price plus the premium received. This means you miss out on further upside.
2. Stock Ownership Risks
You still bear the risk of holding the underlying stock. If the stock price declines significantly, the premium may not offset the losses.
3. Opportunity Cost
In a strong bull market, you may find yourself selling stocks at a lower price than you could have if you hadn't sold the calls.
Conclusion and Additional Considerations
While covered calls can be an effective strategy for generating income and managing risk, they are not without drawbacks. They are not a panacea; they offer benefits but also limitations.
One major point to consider is the risk of 'unbundling' or breaching the covered call position. If the stock price rises significantly above the strike price, you may need to roll the covered call, which can take time and effort. Sometimes, you may need to sell puts to fix a breached call. Additionally, if you keep getting assigned on covered calls, you may miss out on further upside and pay a lot in taxes, as you won’t be able to keep a low cost basis.
Some argue that covered calls may not always be the best strategy. The idea behind covered calls is to collect extra money by selling the right but not the obligation to buy the stock at a specified price before a certain date. The upside is a reduced cost basis, but the downside is that your capital is tied up, and you may miss a chance to sell into a spike in price. If the stock price rises past your strike price, someone else collects all the extra profit, which you cannot.
While covered calls can work well if you are planning to hold the shares for a while and the stock doesn't rise above the strike price, there are instances where they fail. Sometimes, the stock goes down more than the premium received, leading to a loss. In other cases, the price can rise significantly, leaving you with a position that is stuck and cannot gain anymore.
As an example, in a specific instance, I had positions in PANW and PRLB. I sold the premium on both for a few bucks a share. Both stocks rose by ~80 per share, but due to the covered calls, I was only able to sell for ~30-40 per share, losing thousands in potential profits.
Given all these factors, it's clear that covered calls are not always the best or most optimal strategy. While they reduce risk, they also limit potential gains. It's essential to weigh the pros and cons and decide based on individual circumstances and market conditions.