Covered calls are seen as one of the lowest-risk stock investment strategies because you are hedging an existing position through premium income.

But you need to look beyond the benefits of trading stock options through this strategy and assess the covered call risk as well. So, what are the risks of covered calls?

Ultimately, it comes down to opportunity cost and the potential for assignment. If the underlying stock’s price rises above the strike price, you’ll miss out on additional gains – and you’ll have to close out a position you may have wanted to remain long on.

That being said, it’s generally a safe strategy – and the risks of selling covered calls can be offset with a proper options risk management strategy. We’ll share ways to protect yourself from the downside of this strategy and maximize your returns.

Pairing the VectorVest stock software with OptionsPro allows you to not only choose the best stocks to sell covered calls but also pick the perfect strike price and expiration date for your contract to earn the highest premium income while reducing risk. Learn more below!

How Covered Call Options Work

Before we get into the covered call risks, what is a covered call? More broadly speaking, how do stock options work in general?

These are contracts that give the holder the right, but not the obligation, to buy or sell an underlying stock at a predetermined price (the strike price in options) before a predetermined date (the expiration date).

The difference between a call vs put is simple. A call contract gives the holder the right to buy the underlying stock at the strike price before expiration.

In saying that, writing covered calls involves selling these contracts against an open position you already have (hence, the “covered” side of things). Each call contract represents 100 shares, meaning you must own 100 shares to sell covered calls for income.

By selling the call option you earn income known as premium. This is typically just a few dollars per share, but the actual amount will depend on the value of your contract. More on that later.

Now, what happens when options expire? It all depends on how the stock’s price has moved relative to the strike price. If the stock price remains below the strike price, great – the contract will expire worthless as the buyer won’t want to pay more than market value to buy your shares. You pocket the premium income as profit.

On the other hand, if the stock price rises above the strike price you’ll likely see the holder exercise their option to call the shares away from you, which means you have to sell them at a discount relative to market value.

You still earn profit from the sale of your shares, but your upside is capped. Keep that in mind for later as we discuss the risks of covered calls. First, let’s highlight the benefits.

Benefits of Selling Covered Calls

When it comes to learning how to make money trading options, covered calls are very attractive. The premium income you earn from selling these contracts can supplement any gains you’re making from stock appreciation or be used to offset minor dips in portfolio performance.

That being said, learning how to sell options through this strategy is great when you have a flat or moderately bullish outlook on a stock. If it stays relatively range-bound, you can continue to earn profits through premium. This makes it perfect for sideways markets.

Covered calls offer flexibility as well. You can tailor the strategy to your specific needs, being more aggressive and writing options with longer expiration dates or strike prices near the money. You’ll earn more profit this way as you can command higher premiums since the contract has more value in the eyes of the buyer.

Or, you can stick with shorter windows and wider spreads between strike and stock prices to earn more consistent, albeit lower, premium profit. There’s also the concept of rolling options, which allows you to adapt on the fly as market conditions shift.

What are the Risks of Covered Calls?

It’s clear why this strategy is attractive, as you can earn a steady income without exposing yourself to much downside, if any at all. But let’s look at the other side of the coin and discuss why covered calls are bad. What are the risks of covered calls?

Limited Upside Potential

The biggest downside to selling covered calls actually isn’t a risk in the sense that you could face losses – it’s opportunity cost. Call options are binding contracts that require you to sell your shares at a predetermined price should the buyer choose.

If the stock price rises significantly above the strike price, you miss out on those additional gains because you are obligated to sell the stock at the lower strike price.

Now, you’ll still benefit from stock appreciation from your entry price up to the strike price. But, this can be frustrating in a strong bull market where your stock could have delivered higher returns if not for the covered call.

Obligation to Sell Stock

Similarly, being forced to sell your stock can get in the way of building a stock portfolio. You’ll then be forced to wait for stock prices to come back down to enter back in, or buy back in at a higher price.

If you’re investing in dividend stocks specifically, assignment (the process of having to sell your shares after the buyer chooses to exercise their option) could cause you to miss out on big payments you had been budgeting for.

There are also tax implications to be aware of. The unplanned sale could trigger unwanted capital gains taxes. This is something you should learn more about in our guide to taxes on covered calls.

Impact of Market Volatility

While the goal is to choose stocks with relatively low volatility, conditions in the market are always evolving. No investment strategy is immune to this risk, including covered calls.

There are a few different ways high volatility can negatively impact your covered calls strategy. Say stock prices swing dramatically higher – you may be forced to sell your stock. Or, if stock prices plummet, you have an entirely different issue – your portfolio could fall apart. 

For what it’s worth, volatility is a factor across all trading strategies, from long calls vs covered calls to swing trading vs day trading. So, don’t let this deter you from trading stock options as a beginner. Instead, take the time to learn how to offset these covered call risks.

Ways to Offest the Risks of Selling Covered Calls

There’s no way to completely eliminate the risks of covered calls – but you can mitigate them as much as possible and stack the odds in your favor.

We’ll show you a few ways you can set yourself up for success, earning as much premium income as possible while reducing all the risks of selling covered calls.

Choosing the Right Strike Price and Expiration Date

There’s a direct correlation between the strike price and expiration date you choose for your contracts and the likelihood you’ll get assigned. These two factors also influence your premium – the more risk you take on, the more you’ll earn.

This is to say that you can find a balance between profit potential and risk reduction by strategizing the right strike price and expiration date. VectorVest’s OptionsPro has a few tools to assist with this, including:

  • Candlestick Pattern Recognition and Scanning: This feature identifies high-probability candlestick patterns so you can predict potential price movements and choose an optimal strike price.
  • Volatility Range: This indicator analyzes implied volatility to assess whether an option is overpriced or undervalued. Sellers can use it to determine if the current market conditions are favorable for selling options.
  • Sweet Spot Calculation: This tool calculates the ideal timeframe to sell an option so you can capture the maximum premium before time decay accelerates, enhancing profits while minimizing risk.
  • Probability Envelopes: Visualize the likelihood of different outcomes to select the strike and expiration combinations with the highest probability of success.
  • Options Skew: By showing the relationship between strike prices and implied volatility, this graph helps you choose the strike prices that offer the most favorable premiums.

Whether you’re trading futures vs options, you need the OptionsPro integration as a guide for navigating the market. It will save you time and stress while maximizing your upside potential and minimizing the covered call risks.

Picking the Perfect Stocks

The strike price and expiration date you choose are two of the three main moving pieces in a covered call. The other is the underlying stock itself, which is why you need to learn how to pick stocks for options trading.

Ideally, you want stocks that are stable, have low volatility, and offer consistent dividends. They’re less likely to experience sharp price movements that could lead to assignment.

You can learn how to do technical analysis of stocks, or better yet how to combine technical and fundamental analysis. We also have a resource showing you the best stock indicators. But, you can streamline this by simply relying on the best stock picker – VectorVest.

It’s the best app for stock analysis because it gives you everything you need to know to make calculated, emotionless decisions in 3 simple ratings. You’re even offered a buy, sell, or hold recommendation for any given stock at any given time.

You can pull up the list of stocks that align with your strategy – whether it’s the best blue chip dividend stocks, stocks currently undervalued, aggressive growth stocks, or anything in between. You never have to look far for your next opportunity.

So, learn more about how our stock advisory works to enhance your profit potential with a free stock analysis today.

Rolling Covered Calls

Rolling covered calls allows you to adjust your position as market conditions change. The process involves buying back an existing covered call option and simultaneously selling a new one with a different strike price, expiration date, or both.

This can help you lock in profits, extend the duration of your position, or adjust to a new market outlook. For example, if a stock price is approaching the strike price of your current option, you might roll the call up and out – choosing a higher strike price with a later expiration date.

Using Stop-Loss Orders

No matter what strategy you’re executing, put stop-loss orders in place for any position you open. This protects your investment if the underlying stock price drops sharply by automatically closing out your position on your behalf, cutting losses before bad turns to worse.

You want to avoid getting stopped out due to a temporary price dip, though. So, make sure you set the stop-loss order just below a key support level or another critical price point.

Utilizing Covered Call ETFs

Covered call ETFs are a great way to harness the benefits of this strategy without the hassle of managing individual positions. These funds automatically write covered calls on a diversified portfolio of stocks, providing consistent income with reduced effort.

Just be aware that management fees will likely cut into your profits, and you won’t get the same level of customization or flexibility that you would when writing your own calls.

Closing Thoughts on the Covered Call Risks

There’s no denying the appeal of this strategy, but now that you’re aware of the risks of covered calls, it’s up to you to determine if the benefits outweigh the potential downside or vice versa.

Really, though, the risks of selling covered calls are negligible. You’re just capping your upside potential if the stock skyrockets in price, and potentially being forced to sell your shares. Follow our tips on mitigating this risk and set yourself up for success!

The best way to learn options trading is by browsing our blog here at VectorVest. We have tips on when to exercise stock options, warrants vs options, how are options taxed, open interest in options, investment app for beginner, how to short stock with options, and more.

From the best iPhone stock apps to the best Android stock apps, you can’t beat the simple insights awaiting you in VectorVest. You can make more informed decisions with less work and stress, earning higher profits while reducing the covered call risks. Try it risk-free today!