Risky Option: Did Your Advisor Tell You the Risks About Covered Calls?
Covered calls are a way for investors to potentially earn money from stock they already own or which they are intending to buy, in addition to any dividends, or gains from underlying stock price increases. Covered call options can offset the initial cost of buying the stock in the first place. If you are not entirely certain what an option is, have a look at our primer article, “ABCs of Options: What Novice Investors Should Know.”
A call option gives the buyer the right to buy (call) an underlying asset at a specified price and time. The seller (writer) of the call option does not necessarily need to own the underlying stock when selling a call option. In this case, they are called uncovered calls or, more commonly, naked calls.
Writing naked call options is a risky strategy because the writer will suffer double losses if the stock price rises above the strike price—the writer would have to buy the stock at the higher price, then immediately sell it at the strike price, losing the difference paid.
A covered call option means that the writer already owns the stock. These are less risky because the writer will not need to come up with the money to buy a stock they don’t own. If the call option is exercised, the writer still profits from the increase in price and also the premium he or she earned when writing the call option.
Buy-write covered call
In this strategy, the writer does not yet own the underlying stock but wants to buy it. They simultaneously purchase the stock as well as write a call option for that stock. This allows them to offset some of the costs of buying the stock by earning a premium for the call option, although it does open the door to them losing that stock if its price goes above the strike price and the option is exercised by the buyer.
Overwrite covered call
Overwrite covered calls are when the writer sells a call option for stock he or she already owns. This is a common strategy for recouping the costs initially paid when purchasing the stock.
For example, let’s say an investor buys 100 shares of stock XYZ at $100 each, totaling an initial outlay of $10,000. The investor could sell a monthly options contract on those shares for a premium of $500 (minus commissions and fees) and slowly make up the amount they paid for the stock.
Other benefits of writing covered calls include:
- The seller can continue to earn dividends on the stock for the duration of the options contract.
- The premium earned can partially offset any losses through a decline in the underlying share price.
During the life of a call option, three scenarios can occur:
1. Do nothing – The call option’s value can change depending on the market. If the underlying stock price rises, the call option’s value becomes much higher to the buyer. If it lowers, the call option becomes less valuable to the buyer.
Eventually, the option expires worthless if the underlying asset does not rise above the strike price.
2. Close the position (“Buying back” the option)- After writing an options contract, the writer is said to be in an open position. Once an option is written, there is no way to buy back that specific options contract. But there is a way to close the position so that there is no risk of losing the underlying stock if the price has risen above the strike price.
Let’s imagine an investor wrote an options contract for stock XYZ at a $95 strike price. When the option was sold, XYZ was trading at $92. Now it is trading at $94 and the investor fears it might rise above the strike price.
Seeing this, the options writer can buy the same call option as the one they sold, i.e., with the same strike price and expiration date, and thereby close their position. The gain or loss scenario, in this case, is the difference in the premium earned versus the premium paid.
3. Be Assigned – “Being assigned” means that the underlying stock price rose above the strike price and the buyer will very likely exercise the contract. In this case, the options writer must sell the shares at the strike price, thereby losing the potential gain of selling the stock at the higher price.
Furthermore, the selling of the shares is a taxable event and is liable to capital gains tax.
The most common action on the stock market is #2 above—closing the position.
Investors should be aware of the following risks associated with trading in covered calls:
If the options contract is assigned, the investor is obligated to sell the underlying shares. If the strike price is much lower than what the stock has risen to, the investor will forgo all appreciation gains. If the stock has appreciated significantly, the investor can also suffer high capital losses when trying to close out the position. Lastly, covered calls put you on a downside hook if the underlying asset’s price depreciates considerably. Your losses would equate to the difference between your initial stock entry price and the premium you received for the options contract.
There are several things that can trigger a taxable event when writing a covered call option:
- When closing a position, a capital gain or loss is incurred on the position.
- If the option expires worthless, the premium received is considered a capital gain at the time the option was sold.
- If the option is assigned, the underlying shares will trigger a tax event
Suing Your Financial Advisor
Like all investments, options contain risks, and it is possible to suffer enormous losses when engaged in trading them. If your financial adviser is suggesting you trade in options, they are obligated by FINRA rules to answer all your questions regarding them until you are satisfied.