The Real Risks of Covered Calls

Covered calls are often described as a conservative strategy, and in one sense they are: you’re selling options against shares you already own. But “conservative” doesn’t mean “low risk.” Here are the risks, ranked roughly by how much they’ve cost investors.

The eight risks

1. Capped upside, measured

This is the big one. Here are three index covered call funds against the index each one is built on, all starting on the same day:

Each fund paid substantial income. Each one kept only a fraction of its index’s total gain over the same years, and in each case the share price did worse than the index’s price. That’s not a flaw in these particular funds; it’s the strategy doing exactly what it promises in a rising market.

2. Nearly full downside

A covered call position falls almost as fast as the stock. Look at the left side of this chart: the two lines are only separated by the premium.

3. Slow recoveries

After a crash, markets usually recover in a series of strong months. A covered call caps each one. The result is a strategy that falls nearly as far but climbs back much more slowly. Adjust the cap and premium here:

4. NAV erosion

Combine capped upside, full downside and a high payout, and a fund’s share price tends to drift lower over time. It’s the most important risk in income investing today and gets its own detailed lesson next: NAV Erosion: What It Is, Real Examples and How to Avoid It.

5. Income that shrinks when markets calm down

Premium depends on implied volatility. After a scare, premiums are fat and distributions look generous. In long, quiet bull markets, premiums shrink, and with them the income. Ironically, those calm rising markets are also when covered calls give away the most upside.

6. Assignment

If you write calls on individual shares, your best performers are the ones that get called away. Over time, a covered call writer can end up holding the laggards and selling the winners, unless they deliberately buy back or roll calls when a stock surges.

7. Taxes

In a taxable account, premium from calls on individual stocks and most covered call fund distributions are taxed as ordinary income or short-term gains, at your full income tax rate. Writing certain calls can also suspend the holding period that makes your dividends qualified. And assignment is a sale, which can realize a gain you meant to defer. Full details in How Covered Calls Are Taxed.

8. The income illusion

Perhaps the most expensive risk is psychological. A monthly check of $1,000 feels like a $1,000 profit, even when the investment it came from fell by $1,500 over the same time. Investors judge these strategies by the checks, not by the total. The cure is simple and boring: track total return, as described in Total Return: Why the Dividend Is Only Half the Story.