Call Options
Covered Calls Part II - The Downside
By Eric Darby
Nov 11, 2006 - 8:51:00 PM

This is the second of a three-part series on the Covered Call strategy. In Part I we discussed the Upside and the profit potential for the trade. In Part II we will discuss the risks associated with Covered Call trading.
Covered Call writing is a high risk Option strategy in which you have limited upside profit potential and only partial downside protection of the underlying security. The profit potential is maximized with the premium of the short Call and the capital gain on the stock or security you purchased at the strike price at which it could be exercised. Let's consider some of the risks of selling Covered Calls.
Below is a Risk Graph of the Covered Call trade.

Risk of Covered Call Trade

The downside protection is limited to the value of the short Call subtracted from the purchase price of the underlying security. So, if you bought the stock for $15 and sold the near-month call for $2.50, your stock is protected down to $12.50. ($15 minus $2.50 = $12.50). should the stock slide below $12.50, you are losing money on the trade. Theoretically, the stock could go down to zero, which happens, but it could very well decline below $10 and languish there for months on end. The deflated price would be accompanied by deflated Call prices, and it might take you months of selling near-month Calls to get to back to break even if the Calls were between $.20 and $.50.

The situation gets worse if you purchase a $40-$50 stock and it declines $10 or more. Generally, a Covered Call trade is classified as a neutral to bearish strategy. However, as we have seen, the bearish feature is only good down to the breakeven point. After that, it becomes as losing situation and you have no protection. The downside risk is potentially enormous.

But the buy and hold crowd says, "Wait, it will come back." People who bought GM or Intel, for example, at the higher prices in the year 2000 are still waiting to break even. How long can you wait? The street is littered with stocks that haven't yet recovered from the 2000 bubble.

In trading, we like to see a risk to reward ratio of 3:1, where you risk one dollar to make three. In the Covered Call strategy, in our example, we are risking 15 to make 2.50. That is a 6 to 1 ratio in the reverse. You are risking six dollars to make one. Let's say the stock sells for $35 and your Call is sold for $2.50, which is also quite common, that is risking $14 to make 1 dollar. Isn't that a huge capital outlay for such little money?

You could argue that you are making 16% on your money in one month ($2.50 / $15 = 16.67%). It is a good deal if your money is secured by a bank and it is gaining interest. It is not a good deal if you are risking your capital, which might not recover from a down draft in the market.

Another possible downside is having to give up your stock if you bought it cheaply some time ago. IRA accounts are permitted to sell Covered Calls. If you purchased the stock when it was $5 and now it is $15, you may not want to deliver the stock if you are exercised on the short Call. In that case, you would either have to buy back the Call, probably at a higher price or be prepared to deliver the stock if the short Call expires in-the-money.

So, what do you do when considering a Covered Call trade? Part III will explore some of the alternatives and adjustments to Cover Call Trading. We dissect Covered Calls in Trading Stock Options the Easy Way.