Covered calls are a great way to earn additional income while maintaining a long position in a stock you don’t expect to remain fairly stagnant, as you can collect premium from speculative investors. 

But while there’s no denying the upside of learning how to sell options with this specific strategy, it’s also important that you’re fully aware of the risk of selling covered calls. There are three reasons why covered calls are bad:

  1. You limit your upside potential in the long position. Should the stock price climb above the strike price and the option gets exercised, you miss out on additional gains.
  2. Despite collecting premium, you could end up seeing a loss on the trade if the stock’s price plummets.
  3. The actual process of implementing this options trading strategy can be quite complex, especially for new beginners.

That’s not to say you should avoid selling covered calls, though. You can overcome these challenges simply by using the VectorVest stock software paired with OptionsPro.

This dynamic duo helps you elevate your stock picking strategy so you never have to play the guessing game again. Then, you can configure your covered call contracts in a manner that maximizes your premium without exposing you to unnecessary risk.

We’ll walk you through a few option trading risk management strategies below, including leveraging the best app for stock analysis so you can boost your returns while putting the stress behind you for good!

What are Covered Calls?

If you haven’t already taken the time to learn options trading from the ground up, let’s take a step back and start with the basics. 

Options are financial derivatives that give investors the right, but not the obligation, to buy or sell an underlying asset, such as stocks, at a predetermined price within a specific period. There are two styles – call vs put options:

  • Call Options: Give the holder the right to buy an asset at a specified price, known as the strike price, before the option expires.
  • Put Options: Give the holder the right to sell an asset at the strike price before the option expires.

Now – there are two ways you can learn how to make money trading options. You can act as the buyer or the seller of these financial contracts. That being said, let’s get into the details of selling covered calls specifically.

How it Works

A covered call is an options strategy involving two main actions: holding a long position in a stock and selling (writing) call options on that same stock. 

This stock investment strategy is designed to generate income through the premiums received from selling the call option. You could also benefit from stock appreciation – at least, up to a certain point. There are two important components of the options contract:

  • The Strike Price: So, what is strike price in option trading? This is the predetermined price you’ll set when creating your contract that influences the premiums you earn. A wider spread between current stock price and the strike price means it’s less likely the contract will end up in the money (which is good from the sellers perspective) – but it also means you’ll earn lower premiums as the buyer is taking on more risk. 
  • The Expiration Date: Now, when do stock options expire? This is another thing you get to choose as the seller. The longer timeframe your contract is open, the higher premiums you’ll collect as you’re giving the buyer more opportunity to end up in the money. However you’re also taking on more risk as the seller.

As you can imagine, there is a balancing act between setting strike prices and expiration dates that boost your odds as a seller and capturing premiums that make it worth it.

Either way, here’s a quick overview of how selling a covered call works:

  1. Hold the Stock: You own at least 100 shares of a stock (options contracts work in lots of 100).
  2. Sell Call Options: You sell call options against those shares, agreeing to sell the stock at the strike price if the buyer exercises the option.
  3. Receive Premium: You receive a premium for selling the call option.

There are two potential outcomes. If the stock price stays below the strike price, the options expire worthless, and you keep the premium.

On the other hand, if the stock price rises above the strike price, the buyer may exercise the option, at which point you’re required to sell the stock at the strike price. You may still end up profitable, but you miss out on potential income above the strike price.

Advantages of Selling Covered Calls

Before we get into why covered calls are bad, let’s look at the benefits of trading stock options through this strategy:

  • Income Generation: The premiums received from the options sold can be particularly beneficial in a sideways or slightly bullish market where stock prices are relatively stable and you aren’t earning income from stock appreciation.
  • Downside Protection: The premium also provides a cushion against potential losses if the stock price declines. While it doesn’t eliminate the risk, it does reduce the breakeven point.
  • Enhanced Returns: Selling covered calls works exceptionally if you’re investing in dividend stocks, as you can enhance returns by adding the premium income to any dividends received from holding the stock. 
  • Flexibility: You can choose different strike prices and expiration dates to tailor the strategy to your market outlook and risk tolerance.

Why Covered Calls Are Bad: The Risk of Selling Covered Calls 

It’s clear that covered calls present a compelling opportunity. However, it’s essential to understand the risk of selling covered calls as well. Let’s get into the potential downside below.

Limited Upside Potential

The biggest risk of selling covered calls is opportunity cost. You’re placing a limitation on your upside potential compared to simply maintaining a long position in the stock.

When you sell a call option, you agree to sell your stock at the strike price if the option is exercised. This means that if the stock price rises significantly above the strike price, you miss out on those additional gains. 

For example, if you sell a covered call with a strike price of $50 and the stock price rises to $60, you are obligated to sell at $50, thereby capping your profit. If you bought the stock at $45 you still profit $5/share along with the premium earned, but you’ll miss out on that additional $10/per share profit.

Tax Implications

Taxes on options trading are already complex to being with – but they can become even more convoluted when selling covered calls. The premiums received are considered short-term capital gains, which are taxed at a higher rate than long-term capital gains. 

Plus, you may have to pay taxes on any capital gains from the sale of the stock if your stock is called away. This can complicate your tax situation and potentially increase your tax liability.

Risk of Assignment

The buyer exercising their option doesn’t just create opportunity cost problems in the form of limited upside potential – it could interfere with your stock portfolio-building strategy in other ways.

Say you’re blue chip investing in high dividend stocks. If you’re forced to sell your position you’ll then run the risk of missing out on upcoming dividend payouts, which you may have been counting on as a source of income.

Sure, you could simply re-purchase the shares after selling your previous position – but in some cases, it won’t make sense if the stock has risen to the point it’s now overvalued. You’ll be stuck waiting on the sidelines for a better opportunity to buy.

Potential for Loss

So many new options traders make the mistake of thinking that selling covered calls protects them from losses – this is not true. It only mitigates losses to a certain point. 

The premium will offset some level of loss, but likely not all of it in the case that the stock price plummets. Say you have a 100-share position in a stock that sits at $40/share, and you sell a covered call, collecting $100 in premium. If that stock falls to just $30/share, you still end up losing $900 on your position.

It’s worth noting that the risk of stock price drops exists across any strategy, though. This isn’t unique to covered calls.

Are Covered Calls Safe When You Have VectorVest in Your Arsenal, Though?

So, are covered calls worth it in the end? Ultimately, only you can determine if the potential upside outweighs any potential downside. 

However, you can avoid many of the risks we discussed simply by leveraging a proven stock trading system in VectorVest: the best beginner investment app ever created. 

It’s a proven approach that has outperformed the S&P 500 index by 10x over the past 20 years and counting. It can help you streamline how to find stocks for options trading while offering you insights on strike price and expiration date configuration that tip the scale in your favor. Here’s how… 

Proven Guidance in Choosing the Right Stocks

VectorVest is the best stock picking app because it tells you what to buy, when to buy it, and when to sell it at just a glance, saving you time and stress while empowering you to win more trades.

It takes complex technical and financial data and distills it into clear, actionable insights through 3 simple ratings: relative (RV), relative safety (RS), and relative timing (RT). Each is placed on a scale of 0.00-2.00 with 1.00 being the average, making interpretation quick and easy.

Buy beyond giving you a buy, sell, or hold recommendation for any given stock at any given time, you also gain access to a world of possibilities with pre-configured stock screeners. 

You never have to look far for your next trade, whether you’re looking for low-volatility stocks for options trading or the best stocks for beginners, aggressive growth stocks, falling stocks to buy, current undervalued stocks, or anything in between.

Stacking the Odds in Your Favor With OptionsPro

When it comes to selling covered calls, or trading options in general, pairing our stock advisory with OptionsPro dramatically increases your odds of success. 

This suite of tools helps you scan a list of tools and pinpoint those that offer the highest probability of profits, regardless of whether you’re selling or buying options.

You never have to stress about when to sell options or when to exercise options again, either. Specialized theta decay charts show you the perfect moment to make your move either way.

Meanwhile, a unique options implied volatility study helps you determine whether an option is overpriced or undervalued, so you can steer the odds in your favor.

There is even a Sweet Spot calculation that shows you the specific point at which you’ll earn maximum time premium before time decay starts to creep in. This helps you win more often and enjoy quicker profits along the way.

Configuring your options contract becomes effortless as you can look at a skew of strike prices, showing you which offers the best potential for premium in conjunction with expiration dates.

If you’re getting started with stock options for beginners, we believe this is an essential tool in your arsenal to avoid the risks of selling covered calls and stacking the deck in your favor. 

But don’t just take our word for it – get started with the best stock research website and see how much simpler things can be with VectorVest!

Tips on Managing Risk While Maximizing Upside

Even when using VectorVest to offset the risks of selling covered calls, it’s important to use a few risk management tactics as you embark on this investment journey. These include:

  • Select the Right Stocks: Stocks with stable price movements or moderate growth are ideal as they are less likely to have drastic price fluctuations. Ensure high liquidity, too.
  • Moderate Strike Price: A strike price slightly above the current stock price allows for some appreciation while still collecting premium. Setting strike prices too high limits premium, while setting them too low all but guarantees you’ll end up being forced to sell your position and miss out on additional gains.
  • Different Expiry Dates: Use options with various expiration dates to avoid having all options exercised simultaneously. There’s a balance between risk and reward here – the longer out you set expiry dates, the more premium you can collect, but the more likely the contract will end up in the money before expiration. 
  • Roll Options: If the stock price approaches the strike price, consider rolling the option to a later date or higher strike price to maintain your position and collect additional premium.
  • Reinvest Premiums Wisely: Purchase additional shares of the underlying stock or other stable investments with your premiums if you can, facilitating long-term wealth accumulation.

Ultimately, though, the key takeaway from this guide on why covered calls are bad is that you can set yourself up for smooth trading with VectorVest, avoiding many of the risks while maximizing profit. So, get set up today and experience seamless trading firsthand! 

Wrapping Up Our Guide to Why Covered Calls Are Bad 

There you have it – why covered calls are bad. That is, without VectorVest. You could be limit your upside potential, create tax challenges, mess up your portfolio, or deal with losses. 

At the end of the day, though, you could find drawbacks for any investment strategy. Covered calls are not unique in that they carry some level of risk. The question is, does the risk outweigh the reward, or vice versa? Only you can decide.

You can learn more about what happens when options expire, what does open interest mean in options, warrants vs options, how to short a stock with options, trading futures vs options, how do options affect stock price, NQ stock options, free stock analysis websites, stocks vs options what are stock options, or the best technical indicators for options traders in our blog.

But with the best iPhone stock app and best Android stock app just a few clicks away, you’re better off leaving the heavy lifting to a tried-and-true system that supercharges your success rate. 

VectorVest is an essential ally for any investment strategy, but specifically options trading. So, get a free stock analysis today, or start your trial and discover firsthand why the most successful options traders use VectorVest!