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Tuesday, January 29, 2019

Disadvantages of Covered Calls

This article appeared first on enhanced-investing.com
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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.

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