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Pitfalls of Covered Call Writing in the Real World

I have been trading options on stocks and ETFs for over 15 years.

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The covered call strategy is often taught by options educators as something that anybody can use to easily produce regular income from the stock market. Isn't that nice?

The reality is that this strategy can be income producing during periods of non-trending prices and well-behaved markets. But it is a deceptively simple strategy that is by no means easy to implement in a profitable and consistent manner. Covered calls are fraught with problems that can get you into some pretty difficult situations. Let's analyze a few of them...

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Problem 1: You Want to Sell Options with a High Premium and a Low Chance of Exercise

Everyone tells you that most options expire worthless, so naturally you decide to be a seller. But consider the fact that the options that you will want to sell will have to be fairly close to the price of the underlying if you stand to make any money at all.

The ideal scenario would be to sell options that are far away from the price and have a very low chance of going in-the-money before expiration. In actual practice however, options that are way out of the money have a miniscule premium.

So you ignore that and decide to put on the covered call anyway... Thus, what ends up happening is that you sell a longer-term expiration or a closer strike price (or both) than you had originally planned.

Conclusion:

In a trending market, many of your options don't expire worthless. You still make money, but in reality when you get exercised and the stock keeps going you would have made more money without selling the covered calls.

OTM Calls 30 Days Out with SPY at 304

You decide that maybe you should sell a call that is 5% out-of-the-money for the next 30 days but notice that they are only 72 cents. You want to get paid at least 1% for all that risk. So you sell the 310's which are only 2% away.

StrikeBidAskDeltaStrike % Above Current Price

310

3.00

3.03

.2457

2%

315.00

1.44

1.47

.1229

3.6%

319.00

0.72

0.75

.0627

5%

334.00

0.06

0.07

.0019

10%

Problem 2: Large Capital Requirements

I like to sell covered calls on the SPY ETF, because one of the requirements of successful covered call writing is that you don't want the huge swings and gaps associated with individual stocks. But, the problem is that the SPY is currently around $300.00 per share in 2020 and if you want to sell covered calls, you need to own round lots of the underlying. Therefore, if you want to sell just 3 option contracts on the SPY you will have to buy $90,000.00 worth of SPY.

Some people try to replace the underlying with a deep in-the-money LEAP call option in order to make a poor-man covered call. Sure, this will reduce the capital requirements greatly, but it is a completely different trade (a calendar spread) with its own set of even more difficult challenges, so I will not cover such trades here.

Conclusion

The bare minimum capitalization required to sell just 3 covered call contracts on the SPY is more than the average retirement account in the USA, so most people cannot do this safely.

Problem 3: Calls Premiums Don't Protect You As Much As They Should

Everybody says that covered calls are safer than owning stocks outright, and they are correct in saying so. Covered calls really are safe for your broker, and anybody will let you trade them without any margin or experience requirements.

Unfortunately for you, the protection is limited to the premium that you collect. Let's say you sell some option contracts for a 1% credit. If the stock price drops 1% by expiration, that 1% loss is offset perfectly by having collected 1% from your calls. You are happy to do it again as soon as possible...

Sooner or later though, you will experience a gap down after hours and even your automated stops won't be able to save you. It is not uncommon for a stock to correct 20% around earnings announcements. Even a broad index like the S&P500 has had massive up and down days of over 5% several times in 2020.

Conclusion

If the stock crashes, that call premium won't even feel like a small consolation prize compared to the massive loss from the stock. In theory, covered calls are just as "safe" as selling naked puts, because both strategies share the same risk/reward graphs.

The kink on the profit line is where you cap your profits: the strike price. The line under your profit line is your break-even point. The difference between the breakeven point and your profits is the premium that you collect.

The kink on the profit line is where you cap your profits: the strike price. The line under your profit line is your break-even point. The difference between the breakeven point and your profits is the premium that you collect.

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Problem 3: Option Valuation Theory Does Not Work in Favor of Covered Calls

Professional traders allegedly never trade without consulting with their option models first. Since trading could be a zero-sum game and you don't know who is on the other side of your trade, you must at least know your greeks and risk/reward graphs prior to opening a trade if you want to be competitive.

Time decays with a parabolic shape, so you will want to sell options whose thetas are starting to decay increasingly faster towards zero. This usually happens in the last 20 to 30 days until expiration but as stated earlier, you will probably end up selling something less than optimal and with longer expirations than you'd like.

Furthermore, since you are selling out-of-the-money options, a huge portion of the premium is comprised of implied volatility. This means that it is more desirable to sell options when the volatility is high. But, along with high implied volatility, you will be subject to large swings in the price of the underlying, which are difficult to control from a risk management standpoint. You may get stopped out, only to see the stock turn around and go up again.

Conclusion

As stated earlier, the covered call works best when the stock goes up a little or not at all. Under these desirable low-volatility conditions, the out-of-the-money option prices are bound to be worth less than you expect.


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Problem 4: You Cannot Do Covered Calls Consistently

Traders and investors admit that timing is everything. Even Benjamin Graham himself said in Security Analysis that paying the wrong price is just as dangerous as buying the wrong security.

In the Market Wizards book by Jack Schwager, some of the most successful traders in the history of mankind were trend traders, who as a group are known to have low success rates of 30% winners or even less. This proves one thing: the majority of the time, trend traders will be losing money on trade after trade, and then all of a sudden they will catch a big trend that will pay for an entire year's worth of losing trades and then some.

Conclusion

If you are capping your gains month after month trying to make an "income" out of the stock market only one thing is certain. Eventually you will miss the move of the century while ensuring that you are present for every single crash and bear market. Ouch!

Problem 5: The Deer in the Headlights Syndrome

If the stock drops a lot and there are still a lot of days left to expiration, if you decide to close the call, you might notice that the call price didn't drop as much as you expected. This is due to the fact that the premium of an out-of-the-money is mainly composed of implied volatility and theta. And in the case of a sudden drop in the underlying and an inevitable huge spike in volatility, the options can actually go up due to positive vega! The farther away the option price becomes, the less it will be affected by the delta and you may get frozen with the difficult decision of having to buy back an option at a higher price just to get out of the stock.

So you tell yourself that you are a long-term investor and that you have the patience to hold the stock until it comes back. Therefore you do nothing until expiration and by that time the stock has already dropped another 10% (all because you insisted on collecting on that 1% premium).

The call expires worthless and you keep the whole premium, but now you have to decide if you are going to do it again. If you do decide to sell another call, you will almost surely lock in those loses all the way on the bottom of the market. If you choose to wait, it may take months before you are able to sell covered calls again without ensuring that you will get called away and lock in the losses. So long for consistent income from covered calls!

Conclusion

Sudden large drops in the stock are no fun. But if you want to get out, the covered calls can present themselves as an additional obstacle to an already difficult situation. Without a plan, it is easy to become frozen and let a bad situation get worse.

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This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

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