I believe a surprisingly dangerous way to play options are to sell covered calls. This may sound strange to most option traders as it is the most safe convenient ways to use options for long term holdings. Many Individual Retirement Accounts (IRAs) will even allow participants to write covered calls on their stock holdings. How could this seemingly safe way to use options be dangerous?
Let’s think about this option play, where is the risk?
Brokers love to let you sell covered calls, they get the option commissions and you take on all the risk. Risk? Isn’t covered calls a way to generate income? Yes, in an up trending market you can sell covered calls out of the money over and over again and collect the premium and also the capital appreciation in the underlying stock before it gets to your strike price. BUT what about a bear market? In a bear market you are taking on all the downside risk of your stock falling for the compensation of a small option contract premium. You could be collecting $1 in call premiums while your stock is dropping $10 a share, that is a terrible risk return ratio, and if your stock does happen to have a big rally after plunging your recovery is capped at the level of your currently covered call strike. Selling covered calls in a bull market also caps your uptrend gains for a small feel. In a bear market covered calls are shifting all the big downside risk to the person holding the underlying stock and giving the possible up side to the call buyer for a small fee. In a bull market a covered call is a “stop gain” where you will miss out on big trends because you sold the trend above your covered call strike price for a small fee. These are reasons I dislike covered calls.
I would be a buyer of calls in an uptrend not a seller, and I definitely would not be holding stock in a down trend much less for a small call option fee taking on the whole downside risk. A call option gives the buyer of that option contract leverage for a small fee and comes with a built in stop and an unlimited upside, it is a great deal if you know how to buy where the odds are in your favor. Covered call strategies could have long winning streaks but when a stock collapses due to earnings, accounting irregularities, missed earnings, or business missteps you can give back years of profits quickly in the capital gains in the stock and the option premium you have been collecting. In a roaring bear market like 2008 & the beginning of 2009 it could destroy your account to use a covered call strategy by losing up to half your account during the panic and then capping the recovery after March of 2009 if you were still selling covered calls. To truly be successful in the stock market over the long run you have to let your winners run and cut your losses short, covered call options due the exact opposite, they cut your profits short at their strike price but let your losers run as you hold them to sell call options off them over and over again.
Brokers do not mind letting you do covered calls because all the risk is on YOU and you already have your short call option covered with your stock as a hedge. Brokers will let you sell options short as long as you have a hedge because they like to collect commisions. Try to expose them to the risk of you selling an option short with no hedge and watch how they demand a special approval to sell option premium, special margin, and that they will prefer you to hedge your short options with a farther out long option strike. When they are exposed to open ended short option risk they are strict about the parameters, but they will let you sell options agaisnt your stocks when the risk is on you. This is something to thing about.