Why You Should Not Sell Covered Call Options

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Includes: GIS, KO, MCD, MO, PG, SPY, WMT
by: Aristofanis Papadatos

Summary

Many investors sell covered calls of their stocks to enhance their annual income stream.

However, this extra income comes at a high opportunity cost.

Investors should not set a low cap on their potential profits.

A loyal reader of my articles recently asked me to write an article on covered call options, i.e., call options of a stock that are secured by the related shares of the stock in the portfolio. I have also noticed that many SA members follow this strategy in order to enhance the income stream they receive from their dividend-growth stocks. Nevertheless, in this article, I will analyze why investors should resist the temptation to sell covered call options.

First of all, it should not be surprising that many investors like selling covered calls of their stocks to enhance their annual income. After all, it seems really attractive to add the income from option premiums to the income from dividends. This is particularly true during rough periods, in which the market is either in a downtrend or in a range-bound mode, such as the 2-year period from the fall of 2014 to the fall of 2016, when S&P (NYSEARCA:SPY) remained essentially flat.

In order to earn meaningful premiums from the call options that expire in January, which are the most liquid ones, investors should sell calls that have a strike price that is maximum 10% higher than the current stock price. If they choose a higher strike price, the premiums will be negligible. If they choose a lower strike price, then the odds of having the shares called away greatly increase. Therefore, there seems to be an optimum, which lies somewhere around the 10% margin over the prevailing stock price. The table below shows the current stock prices of some dividend aristocrats, namely Coca-Cola (NYSE:KO), Altria (NYSE:MO), Procter & Gamble (NYSE:PG), Wal-Mart (NYSE:WMT), McDonald's (NYSE:MCD) and General Mills (NYSE:GIS), the strike prices of their call options and the premiums they offer.

Ticker

Current Stock price ($)

Strike of Calls ($)

Premium ($)

Annualized yield

KO

42.12

47

0.45

1,28%

MO

75.67

82.5

1.35

2,14%

PG

91.40

100

1

1,84%

WMT

70.58

77.5

1.45

2,47%

MCD

127.88

140

2.30

2,16%

GIS

61.16

67.5

1.50

2,94%

As shown above, the approximate annual return from the premiums of the covered calls is 1%-3%. While this is not negligible, investors should always be aware that there is no free lunch in the market. More specifically, the average historical return of S&P is 8.6% per year. In addition, investors will be hard-pressed to find a dividend aristocrat that has not appreciated more than 10% for more than a year during the ongoing bull market. Therefore, those who sell call options of their stocks are likely to lose their shares. This is a drawback that is certainly undesirable to most investors, particularly to those who keep their stocks with a long-term horizon.

Of course this strategy is likely to work well in a rough market, as the shares are unlikely to be called away and the income from the option premiums will console investors for their capital losses. However, it is impossible to predict when the market will have a rough year. To be sure, numerous "experts" have been calling the end of the ongoing 8-year bull market since its very beginning. Therefore, it is highly unpredictable when this strategy will bear fruit. Moreover, investors should keep in mind that the market spends much more time in uptrends than in downtrends. To be sure, the average bull market has lasted 31 months while the average bear market has lasted only 10 months.

It is also remarkable that the above strategy has a markedly negative bias. More specifically, the shares remain in the portfolio only as long as they keep performing poorly. Instead, when they rally, they are called away. Consequently, investors who sell covered calls bear the full market risk of these stocks while they put a cap on their potential profits. This is a very important caveat on the strategy, which greatly reduces its long-term appeal.

Investors who prefer the stock market from the safety of bonds or deposits make this choice thanks to all the wonderful things that can happen in the stock market thanks to corporate America. For instance, a company can keep growing for years and can thus offer excellent returns to its shareholders. Moreover, it may become a takeover target at some point and hence its shareholders can earn a high premium on its market price. Therefore, it is really important for stock investors to remain exposed to all the potential gifts they can receive from their stocks instead of setting a low cap on their potential profits.

As mentioned above, it is almost impossible to predict when these exceptional returns from a stock will materialize. For instance, the stock of McDonald's had remained essentially flat for 4 years, until late 2015, due to the absence of growth, but suddenly returned to its growth trajectory and rallied 30% in less than a year. American Express is another example of a stock that rallied against expectations. While the stock plunged due to the loss of some key customers and the heating competition, it has rallied almost 60% off its low about a year ago. S&P also surprised most investors with its recent rally. As S&P traded within a very narrow range for two years, most "experts" rushed to call the end of the bull market. However, S&P has proved them all wrong as it has rallied 13% since the recent elections. All in all, it is impossible to predict when the great returns from S&P or specific stocks will materialize. Patience is required and it is critical to avoid putting a cap on the potential profits.

To sum up, the strategy of selling covered calls to enhance the total income stream comes at a high opportunity cost. On the one hand, if a portfolio has a poor selection of stocks, then the strategy will bear fruit and mitigate capital losses by 1%-3% per year. However, on the other hand, if a portfolio consists of stocks with solid prospects, then the above strategy will prove highly detrimental, as the stocks will be called away when they experience a rally. Therefore, investors should resist the temptation of the extra income and remain exposed to the upside of their stocks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.