Investment professionals routinely encourage investors to engage in a covered call writing strategy. A covered call writing program sells options against stock positions that the investor owns. For example, if XYZ stock is currently trading at $19.50, and the investment professional sells the December $20.00 call for $1.00, the investor may receive $100.00 for every 100 share increment owned. 1 option is the equivalent of 100 shares of stock. So if the investor owned 100 shares of XYZ stock, they would receive $100.00 of income for the call sale.
If XYZ stock trades at or close to current levels, the December $20.00 call may expire worthless, and the investor keeps the full premium and the underlying stock. The problem for the investor in a covered call writing strategy is if the stock moves dramatically up or down. If the stock drops significantly, there is nothing to protect an investor on the downside. If XYZ moves from $19.50 to $15.00 the investor has the $1.00 per share of options premium/income, however, that leaves them with a $3.50 per share loss. The flip side is when the price of XYZ rises dramatically. If XYZ stock rises from $19.50 to $24.00 before the end of December, the investor’s option will be called away by the purchaser of that $20.00 call. As a result, the investor will have sold a stock that is trading at $24.00, for the equivalent of $21.00 a share ($20.00 plus $1.00 of option premium received), or $3.00 less than the market the rate.
Unless the investment professional is recommending this problematic strategy in a wrap/fee-based account, the strategy is actively managed and traded, which ultimately leads to greater commissions charged to the investor. All three examples above will lead to additional trades. If the stock trades in a tight range just below $20.00, the option will expire worthless. The investment professional will likely sell another call option with a different future expiration date. If the price of the stock drops significantly the December $20.00 call will expire worthless. The investment professional will likely sell another call option. After the price decline, the investment professional will have to go out at least a year or more to get $1.00 in premium for a $20.00 call. This will ultimately cap the investor’s upside for a longer period of time, while still providing no downside protection. The last scenario is when the stock gets called away when the underlying stock price rises dramatically. The stock that is called away at $20.00 generates a commission. Then the investment professional will likely recommend buying another stock and selling a covered call against that position. This recommendation ultimately leads to at least two more commissions.
No matter what direction the price of the underlying stock trades, the investment professional always wins. The only situation that may potentially benefit the investor is when a stock price more or less stays the same. Given how the markets have traded up and down over the past decade, a scenario where market stay stagnant long-term is highly unlikely. Accordingly, recommending a strategy that caps your upside and fails to protect the downside is likely done out of self-interest.