In recent years, investors have shown more interest in calls as one of many options-style trading strategies available to produce income. Investors like the idea of a limited short-term risk for a limited return while waiting for market changes to provide them with better opportunities. The popularity of covered calls as a long-term, low-risk strategy has fueled online searches using the phrase “Are covered call strategies a good call?” to such a high degree that we believe it’s critical to break down the pros and cons of this investment tool to help uninitiated investors to understand the actual risks.
What Are Call Options?
A seller and a buyer agree to a contract, also known as a “call option” or “call,” that puts in writing their agreement to a set price for a security exchange for every 100 shares of a specific stock. The seller, also known as the writer, must sell to the buyer if the buyer decides to move forward. The buyer isn’t required to purchase the agreed-upon quantity for the price, also known as a strike price, before a specific expiration date. They’re merely buying the right to demand the shares at the agreed-upon price. The buyer pays a fee, or premium, for this right.
What Are Covered Calls?
In a standard call scenario, the owner of the security offered in the call can take the stock from the seller at expiration. With a covered call, the owner and the trader-seller are the same person. This scenario provides the trader with some income from the premiums gained for writing the call. This strategy is often employed by investors hoping to generate some reliable income while waiting for positive market changes.
What Are the Upsides?
With a covered call buy-write strategy, an investor hopes for a good yield and low volatility. If the stock finishes by the expiration date below the strike price, the seller keeps both their stock and the premium. If the buyer demands the stock, the seller keeps only the premium. If the call expires without providing the seller enough value, the seller can write another call.
What Are the Downsides?
The initial stock investment requires that the seller have enough necessary capital. While investing in a covered call strategy, they lose potential gains from the stock price finishing higher than the strike price. If the stock finishes above the strike price, the seller loses anything beyond the strike price. The seller loses even more money if the stock price drops too low, especially if the stock drops to $0 because of the loss of the initial investment.
Additionally, any earnings from this strategy represent taxable income. More importantly, investors who choose long-period covered calls instead of other investment strategies increase their risk for the simple reason that these types of covered calls have underperformed historically, except during financial crises during years when stock prices overall declined. During those years, seller investors at least gained income from premiums.
Who Should Use Covered Calls?
Covered calls require the right market timing, which isn’t easy to gauge for investors. An investor must have the right experience. They must possess the knowledge and skill to predict market changes. Financial professionals who deal with market prediction daily, such as portfolio managers and traders, have the knowledge and predictive abilities that investors without a professional background lack. Yet, even they lose money. Most financial experts agree that market timing works best as a short-term strategy for investors with extensive, up-to-date knowledge and the time to watch the market actively across hourly or daily intervals.
When Should Investors Use This Strategy?
The best time to make this type of investment is when a stock’s history doesn’t include wide fluctuations in price. Also, all predictions suggest stability or a neutral prospect. The seller doesn’t want the stock price to drop too low or rise too high beyond the strike price. The seller’s primary goal is to make money off the call in the form of a high premium without the buyer ever actually taking them up on the offer. Even if the stock is called away by the buyer, the seller faces tax liabilities.
Professional Services Decrease Risk
Traders hoping to use a covered call reduce risk with knowledge and the right portfolio management tools. Instead of asking only “Are covered calls a good call?” during an online search, they must also consider “What tools are needed to make covered calls a good call?,” and then seek the best ones available today. Additionally, it’s important to note that investors can sell a portfolio stake to earn money at a lower tax rate without using a covered call strategy.
At Fund Studio, our team has created a system that handles integrated, real-time portfolio operations and reporting to the degree needed to help manage market changes more accurately and handle investments as optimally as possible. Our services include risk analytics with a comprehensive risk-based framework. Our team also provides middle-office managed services to help clients handle certain aspects of their daily operations. This service gives clients more time for decision-making and considering a diverse range of strategies.
For more information, contact our Fund Studio team by phone at (201) 242-1522 or email at sales@objecutive.com.