Despite the fact that a disciplined covered call strategy can out
perform an equity index in the long run and do it with less volatility
risks obviously exist as with any strategy.
- When you sell a Call on a stock that you are holding, you are
limiting your upside potential. It gets capped at the short strike price
of the Call you sold, so you will not participate in an entire stock
rally. However, you are still exposed to downside moves just as a
regular shareholder.
- When you are short Calls, you are also short volatility (Vega). A
strong decline in the stock may actually make the Call more expensive
or not lose that much value do to the expansion of volatility. Of
course, this is irrelevant at expiration date when all that matters is
whether the stock is above or below the strike price of the Call option.
- Because it is an active strategy, profits are taxed at higher
rates than say dividends or capital gains. This is something to take
into account if you want to avoid active trading taxes. In that cases it
is better to apply the strategy in tax sheltered accounts such an IRA.
- Also, because it is an active strategy you will incur more
trading costs than a pure passive Buy&Hold Investor. It is important
for this reason to use a broker than charges reasonable commissions of
less than $1 per contract and no Order Ticket charge.
All that said, Covered Calls help you mitigate your equity losses and
can also provide regular cash flow. Evidence shows that a systematic
Covered Call approach on the S&P500, selling the 30 delta Out of the
Money Call every month while holding the underlying instrument, beats
the index handsomely and with less volatility. Read
this article about
CBOE’s BXY index.
The disciplined investor will simply have to fight the frustration of
missing huge rallies, knowing that for each one of those, there will be
dozens of stocks doing nothing, sometimes for years. So, things tend to
even out in the end and turn out a little better for the Covered Call
seller.
