Why Covered Calls Are Bad: Risks and Drawbacks Explained

Covered calls, a popular strategy among investors seeking additional income from their stock holdings, involve selling call options on stocks they own. While this approach can generate extra cash flow, it is not without its downsides and potential pitfalls. Understanding these risks is crucial before deciding to implement covered calls in an investment portfolio.

Limited Profit Potential

Covered calls generate income through option premiums but cap the upside potential of the underlying stock. By selling a call option, investors agree to sell their stock at a predetermined strike price if exercised. This means that regardless of how high the stock price climbs, the investor’s profit is limited to the strike price plus the premium received. For instance, if an investor owns shares of a company trading at $50 and sells a call option with a strike price of $55, their maximum gain is $5 per share plus the premium, even if the stock rises to $70.

This limitation can be frustrating in a bull market where stocks experience significant appreciation. Investors may miss out on substantial gains, as the call option obligates them to sell their shares at the lower strike price. The opportunity cost of foregone profits can be considerable, especially in an upward-trending market. Investors must weigh the income from premiums against the potential loss of larger capital gains.

Risk of Stock Being Called Away

A major risk of covered calls is the possibility of the underlying stock being called away. This happens when the stock price exceeds the strike price, prompting the option holder to exercise their right to purchase the stock. For investors, this means selling their shares at the strike price, regardless of further appreciation in value. This can be disheartening if the stock continues to rally, leaving the investor with missed opportunities.

The timing of a stock being called away can be unpredictable, influenced by market events, earnings announcements, or unexpected news that causes a price spike. This unpredictability can disrupt an investor’s long-term strategy, especially if the stock was intended for prolonged holding to benefit from growth or dividends. Additionally, the forced sale of shares can trigger capital gains taxes, potentially complicating financial planning.

Impact of Market Volatility

Market volatility plays a significant role in covered call strategies, affecting both option pricing and the likelihood of exercise. During periods of high volatility, option premiums increase, offering higher income potential for selling calls. However, this comes with heightened uncertainty. Rapid stock price fluctuations make it difficult to predict whether shares will be called away or retained.

The Chicago Board Options Exchange Volatility Index (VIX), often referred to as the “fear gauge,” reflects market uncertainty. A rising VIX signals increased volatility, which can lead to wider bid-ask spreads and erratic price movements. This environment can challenge covered call writers, as stock prices may quickly surpass the strike price, leading to unexpected assignments.

Regulatory changes and macroeconomic factors can exacerbate volatility. Announcements on interest rates or fiscal policy shifts can trigger sudden market changes, complicating the execution of covered call strategies. Investors must consistently reassess their positions and adapt to changing conditions to manage risk effectively.

Tax Implications

The tax implications of covered calls can impact overall returns. Premiums received from writing covered calls are considered short-term capital gains and taxed at ordinary income rates, which can reach as high as 37% under current U.S. tax laws. This significantly reduces the after-tax income generated by the strategy.

If the stock is called away, additional tax consequences arise. The sale of the stock results in a capital gain or loss, depending on the original purchase price. Stocks held for over a year qualify for long-term capital gains taxed at a lower rate, while those held for less than a year are taxed at higher ordinary income rates. Timing thus becomes a critical factor in minimizing the tax burden.

Opportunity Cost

Investors implementing covered calls must consider the opportunity cost of tying up their capital in this strategy versus exploring other investments. Selling call options limits the ability to fully benefit from significant stock price appreciation. Additionally, the capital could have been allocated to strategies with higher growth potential or better alignment with market conditions.

In a rising market, investors focusing on growth stocks or sector-specific exchange-traded funds (ETFs) may achieve greater returns than those constrained by covered call obligations. Capital tied to the underlying stock could have been used for other income-generating strategies, such as dividend reinvestment plans (DRIPs) or real estate investment trusts (REITs), which offer both income and long-term appreciation.

Covered calls can also lead to a lack of diversification. Investors may become overly concentrated in a single stock or sector to generate premiums, missing opportunities to balance risk across asset classes. For example, an investor heavily invested in technology stocks for covered calls may forgo exposure to defensive sectors like utilities or healthcare, increasing portfolio risk during market downturns.

Complexity and Management Effort

Although covered calls are often marketed as straightforward, they require ongoing management and a level of complexity some investors may underestimate. Unlike passive buy-and-hold strategies, covered calls demand constant monitoring of stock prices, expiration dates, and changes in implied volatility. Investors must decide whether to roll, close, or let options expire based on these factors.

Managing multiple positions adds to this administrative burden. Writing calls on several stocks requires tracking each position’s performance and adjusting strategies as market conditions evolve. Rolling options to different expiration dates or strike prices often incurs additional transaction costs. These adjustments require not only time but also a solid understanding of options pricing to determine financial advantages.

Early assignment adds another layer of unpredictability. Call options can be exercised before expiration, especially if the stock pays a dividend and the option is in-the-money. Investors must be prepared to either deliver shares or buy back the option at a potentially unfavorable price. For those lacking a strong grasp of options mechanics, these scenarios can lead to costly mistakes, undermining the strategy’s benefits.