Covered call writing is an investment strategy often described as a way to increase your income from a particular stock. There certainly is a lot of misinformation around the concept of covered calls. The primary area of misinformation relates to risk. Very little  time is devoted to explaining the risks of the covered call strategy or worse it is touted as being a risk free investment strategy (there is no such thing as a risk free investment).

For those unfamiliar with covered calls it is a process in which you, the investor, owns an underlying stock and then you sell a derivative product, called a call option on that same stock. A call option gives the holder of that option the right, but not the obligation, to buy a stock at some point within a specified period of time, for a specified price.

The best way to think of a call option is to think of a coupon. A coupon gives you the right to but not the obligation to buy a particular item (lets say a pizza), at a particular price ($5.99 for arguments sake), for a specified period of time (until the expiration of the coupon). A call option is no different except that you have to buy the coupon, it is not free. For example, you could buy a call option that would give you the right to buy a stock for $21.00 until August and today the stock is priced at $20.00. Obviously if the stock doesn’t go above $21.00 before August your option was worthless, but if the stock goes to $25.00 by August you have made $4.00 on your call option. If you bought that call option for $2.00 then you just doubled your money!

A covered call is when you are the person that sells the $21.00 option. You have made $2.00 for selling that option. If you just sold the option and didn’t own the stock at $20.00 then you have exposed yourself to unlimited risk. If the stock goes to $100.00 by  August, for some reason, then you have just lost $79.00! This is because you are forced to sell the stock to someone at $21.00, but in order to sell the stock you must first by it for $100.00…ouch.

The solution to this dilemma is to sell the call and buy the stock at today’s price of $20.00. Therefore if the stock dose go to $100.00 and you are forced to sell it at $21.00 then you are selling a stock that you bought for $20.00 at a price of $21.00 instead of selling a stock that you bought for $100.00 at a price of $21.00. This is what is called a covered call.

Covered calls sound great! The problem with them lies in a very subtle risk. This is the risk of limiting your upside potential, while leaving you with all of your downside potential. In fact because of this one unnoticeable risk, any covered call strategy implemented over the period of 1990 to 2010 on an index such as the S&P 500 would have underperformed that index. In fact using a strategy of selling “at the money calls” each month would have increased the value of your 100% index fund portfolio by only 25% total! This is over a time period where a standard investment in that same index (S&P 500) would have well over tripled your money!

There are other flaws with the covered call strategy, such as the fact that you will have to buy round lots (100 shares of stock at a time) in order for your stock to be “covered,” because options are only sold in 100 share increments. This makes position sizing within your portfolio quite difficult, which makes risk management even more difficult.

In conclusion, a strategy of selling monthly or yearly covered calls to boost you income, will negatively effect the performance of your portfolio. In reality, it will increase the risk of your investment and decrease your income over time, which is the exact opposite of what the strategy aims to do.

I have to apologize, if this post seemed complicated, options can be tricky things, but I just wanted to point out the why this popular option strategy is doomed to fail. If you have any questions or comments please comment. Thanks!