The Downside of a Covered Call

I recently wrote a post about the benefits of using a covered call, but there is also a downside to using covered calls. While a covered call provides some protection to a long stock position, and serves to smooth price swings, it is far from a hedge for the long position. It should by no means be considered protection against a fall in stock price.

Many investors believe selling a call provides protection, and that by selling a call they will not lose money on their long position. The premium you will receive from selling short a call against a long position provides very limited protection, and will not make up for a large, or even moderate, loss in the stock.

The amount of the offset provided by the short call, from the loss of value in the long stock, depends both on the amount of premium sold, and whether or not you hold the call to expiration, or cover the short call and sell the underlying stock.

You can also roll your calls, either up or down, depending on where the stock is and whether or not you wish to keep the long position. Rolling a call involves covering the short call, and shorting another call at either a different strike, expiration date, or both. Sometimes it makes sense to keep the long position for tax purposes.

If the point of using an option is to provide protection for your long stock, the simplest way to get that protection is to buy a put. A put allows you to sell, or put, your stock to the put seller at a predetermined price, the strike price. Just like a call, a put will have an expiration date and will only provide protection through that date.

The value of your put will rise in proportion to the decline in value of your long stock, minus the premium paid for the put, which will decline as the stock declines.

If you are comfortable with both puts and calls, and either your stock is going through large price swings, or an earnings release is approaching, you may want to put on a collar trade. A collar trade consists of being long stock, short a call and long a put.

A collar trade should generally be used over a time period in which the stock you are long is acting in a more volatile manner than you expected when you purchased the stock.