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The Many Pitfalls Of Selling Covered Calls

The following is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences with anyone who is interested.

Do You Want Fries with Your Covered Call?

A covered call is one of the simplest option trades, which may be one reason that in recent years some brokers have reported that as many as 85% of traders are using the strategy. However, just because it is popular does not necessarily imply that it is profitable. The performance of one mutual fund that utilizes covered calls, Eaton Vance Risk Managed Equity Option (MUTF:EROAX), reveals the very real possibility of potential losses. While the 1-year performance of the S&P 500 is nearly flat, the funds shares are down nearly 7%.

Why would 85% of traders be using the same option strategy unless it was highly profitable? The short answer is that covered calls are the 'fast food' of the options market. They are quick, easy trades that are simple to understand. Most often, these trades are only open for a few weeks at a time, so a trader can get in and out without a long-term investment. Given the potential for speedy profits, and the huge volume of advertising dedicated to luring new traders, their eventual popularity was likely inevitable. In good times they are coveted by many. Sellers get a decent income while the call buyers get great percentage returns, and brokers cash in on the commissions without taking on the risks inherent in some option trades.

Those not familiar with covered calls might be surprised to learn just how simple it is to trade them. Almost any trader who wishes to do so can get paid to buy practically any stock or ETF he chooses. With a few clicks of a mouse, the trader buys 100 shares of stock and then sells a call option. Most commonly, the trader agrees to hold the stock until the third Friday of the month at which time the buyer is expected to take possession.

Simple and fast? - Yes.

Profitable? - Not so fast.

In reality, selling covered calls can be as unfulfilling as selling burgers at a fast food restaurant. The call seller is doing all of the work; buying the stock, holding it for a period of time, and giving away most of the profits, in return for a small fee. While the odds are strongly in favor of the seller generating income during good times, the loss of income during tough times can be devastating. A market correction or a bear market will eventually occur. When it happens not only does the potential income diminish or disappear all together, but the call seller can be left holding a stock that can not be sold without taking a substantial loss. During strong rallies, covered call sellers may feel as if they are working for minimum wage while everyone else is getting wealthy. When the market moves sideways, they may become a nervous wreck waiting for expiration day. When the market reverses, they may feel as if Wall Street has just ordered dinner and then stuck them with the bill.

Selling covered calls for consistent profits is a challenge even for professional managers of mutual funds, so what chance does an individual trader have? Probably not much, at least over the long term. The strategy might best be described as entry-level work in the field of options. Learning how to trade it can be a valuable first step in beginning a career; however, it is seldom the final step. While there is an almost endless demand for new traders, the pay is rarely as dependable as other option techniques. Turnover is high, and the working conditions are frequently stressful. Despite the prospect of getting paid to trade stocks, a trader who seeks to retire from the workforce by exclusively selling covered calls may ultimately find himself thinking that he should be asking his customers, "Do you want fries with your covered call?"

Questions or comments about covered calls or any other option strategy are encouraged. Feel free to enter them in the comment section below.

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