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The Facts About Covered Calls
Traders Magazine Online News, August 27, 2018
The covered call is one of most common option strategies there is, but it isn't going to be right for every situation. It can sometimes be a sound strategy, and other times it might not be. What's important to understand is that the covered call does have significant history and academic research behind it, making it clear that it can be an ally for investors, even though it can also underperform a long-only approach in certain market conditions.
Here's a recap of the strategy. A covered call involves an investor being long shares of a stock or an exchange-traded fund, then selling a call option against 100 shares of the underlying security. The covered call can do a few things: 1) provide income from selling the call, 2) establish an exit point from a position, 3) lower the cost basis of the underlying security's acquisition and 4) offer a degree of protection during a downturn.
Those are positives. However, that doesn't mean selling covered calls is a way to guarantee higher returns or even positive returns on an initial position. As with all investing strategies, covered calls have to be understood well, for both their strengths and weaknesses, and deployed after the proper analysis has been conducted.
During a bull market, the covered call may be less than ideal compared with being simply long equity. The reason is that selling calls, even those that are out-of-the-money, exposes the investor to the underlying stock or ETF being called away when it rises above the strike price. This is the key tradeoff with the covered call strategy - while it does provide income, it simultaneously places a ceiling on potential gains. In other words, you can reduce your risk, but you will also reduce the opportunity for reward.
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