Can You Lose Money on Covered Calls?
Beyond perception: understand how covered calls, despite their reputation, can lead to real financial losses for investors.
A covered call involves selling a call option against shares of stock an investor already owns, typically to generate income. While often seen as conservative, investors can lose money with this strategy. This article explores scenarios where financial losses can occur.
When the Underlying Stock Price Declines
The primary way an investor can lose money with a covered call is through a decline in the underlying stock’s price. If the market value of these shares falls, the capital loss on the stock can outweigh the premium received from selling the call option.
For instance, an investor might purchase 100 shares of a company at $100 per share and simultaneously sell a call option with a strike price of $105, receiving a premium of $2 per share, or $200 total. If the stock price subsequently drops to $80 per share, the investor has an unrealized loss of $20 per share on the stock, totaling $2,000. Even with the $200 premium collected, the net loss on the position is $1,800.
The premium provides a small buffer against a stock price downturn, lowering the breakeven point. However, this premium does not offer complete protection against significant depreciation. A market correction or adverse company news can lead to substantial stock price declines. The premium is typically a small fraction of the stock’s value and cannot fully mitigate large percentage drops. The main driver of loss in a covered call position is the depreciation in the value of the owned stock.
Calculating Overall Profit or Loss
Calculating the net profit or loss of a covered call position combines the stock’s financial outcome with the premium received. The premium provides an immediate credit, reducing the stock’s initial cost basis. However, this credit may be insufficient to offset a substantial decrease in the stock’s market value.
Consider an investor who buys 100 shares of stock at $50 per share and sells a call option for a $1.50 premium, setting the strike price at $55. The total initial investment for the stock is $5,000, and the premium collected is $150. If the stock price falls to $40 per share by the option’s expiration, the shares are now worth $4,000.
The capital loss on the stock is $1,000 ($5,000 initial value – $4,000 current value). After accounting for the $150 premium received, the net loss on the entire covered call position is $850 ($1,000 stock loss – $150 premium gain). This demonstrates how a decline in the stock’s value directly translates to a net loss for the investor, even with the premium collected. Conversely, if the stock price had risen to $52, the investor would still hold the shares, which are now worth $5,200. The gain on the stock is $200, and when combined with the $150 premium, the total profit is $350. However, if the stock price had soared to $60, the shares would likely be called away at the $55 strike price, resulting in a $5 per share gain on the stock ($55 – $50) plus the $1.50 premium, for a total profit of $6.50 per share, or $650. These calculations illustrate that while the premium enhances returns in favorable or flat markets, it cannot prevent a net capital loss when the underlying stock declines significantly.
Impact of Transaction Expenses
Transaction expenses are a direct cost that can erode covered call profitability, potentially turning a theoretical gain into a net loss. These costs include fees charged by brokerage firms and exchanges for executing trades. Investors typically incur commissions for buying the underlying stock and selling the call option.
For example, a brokerage might charge a flat fee of $0.65 per option contract, meaning selling one covered call contract would cost $65. If the premium received for that contract is only $150, the effective net premium collected is reduced to $85. For investors engaging in frequent covered call trades or those dealing with smaller premiums, these fees can significantly diminish the overall return.
Other expenses, such as regulatory, clearing, and exchange fees, also accumulate. These costs are subtracted from any premium received, reducing the buffer against stock price declines. If the stock price remains stable or declines slightly, transaction costs can push the position into a net loss. When evaluating profitability, factor in all associated trading costs to determine the true net financial outcome.