You can earn income from selling the call, but if the position rises to the specified strike price prior to the time the option expires, you may have to sell the stock at the strike price to the owner of the call option.
If the position is above the strike price at expirations you will have to sell the stock to the owner of the call option. If the stock price does not rise to the strike price, you keep the stock and the premium from selling the call option when the option expires.
At first glance the worst case scenario seems to be that you are forced to hand over your stock at a lower price then where it is currently priced. You receive the immediate income from selling the put, just like the covered call. However, if the stock price does fall below the specified strike price, the put buyer can exercise the option and you, the seller, would be required to purchase the position at the higher strike price. Essentially, the stock price could plummet all the way down to zero—so the potential loss is the difference between the strike price and zero.
If that happened, you would have to purchase the stock at the strike price, even though the stock is now worthless.
However, appearances—and adjectives—can be deceiving. When you examine covered calls and naked puts from a mathematical level, you find that they end up with the same payout. Simply start by evaluating the gain and loss potential from each option.
Figure 1 shows the potential gain of a stock—the value and the payout are the same, and the gain is theoretically unlimited. The potential loss is the purchase price. Figure 2 shows the potential payout of writing a call option. The highest gain is limited to the premium received from selling the option. However, there is unlimited loss potential if you do not hold the security in question. Also, the amount of net worth allocated to stocks can be tied up in positions that have dropped in price due to an overall bear market.
The plan is to sell covered calls for the month with these stocks as the underlying positions. While there are many more bull market years than bear market years, bear markets are a fact of life for stock investors.
Almost all investors own stocks, however, and are subject to stock market risk anyway. This is why covered calls can make sense for investors who already are exposed to stock market risk. Granted, it may take shifting out of some stocks or funds to get started selling covered calls for most investors, but this is very doable.
There are a few ways to lessen bear market risk as it relates to covered calls, if not avoid it entirely, as explained below with 4 solutions. One way to lessen the probability of this problem is to reduce stock market risk as stocks become overvalued. Investors can by this by increasing cash money market or Treasury bond holdings to lower risk. Note that nn investor could even sell call options against a bond ETF in this case.
Investment money could be switched back into stocks or stock ETFs after stock prices have become cheap again. Click here to read my post on cash portfolio in a allocation. One of the best covered call strategies to protect investors from bear markets is accomplished by purchasing puts on covered call stock holdings. And the call you sold will decrease in value as the stock drops allowing the option to expire worthless or giving a covered call investor the option to buy back the call option.
While buying a put will reduce overall income from a covered call, it will reduce the risk, too. Think of buying a put as insurance, which is never free.
Also, the income from the call option pays for the cost of the put when structured properly. There are other more complex option strategies that can be used to generate option income, but simple strategies suit my investing personality better. My husband, Larry, on the other hand, teaches more advanced option strategies after being a professional trader for over 30 years.
When the overall stock market is expensive, I seek out undervalued stocks for covered call strategies. While these stocks will probably drop during a bear market, since they are already undervalued, they tend to fall softer than high flying growth stocks. So the counter-argument is nonsensical on its face. How can producing cash flow from an asset increase the inherent risk of owning the asset? He wants a return on his money: cash flow. This Wall Street disinformation campaign makes sense historically, though.
Brokerage firms used to make a lot of their money through horrendously large commissions on client trades. Of course they recommended buying stocks. Brokers in particular fear liability when customers lose money, even on self-directed options-related trades, and they make little off option transactions. Your choices are to rely on their advice that is, buy what they peddle or handle your own investing. What should you do? But if you will trade, then you must make choices — and thus you must predict.
This series of articles unapologetically makes a case, hopefully a persuasive one, for the ease, predictability and power of covered call writing as a consistent income generator acceptable to conservative investors. Every public company, every business, in fact, is valued and measured by its cash flow. You know, our Grandfathers understood that.
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