Covered Calls

IN SEARCH OF EXTRA income, investors sometimes skip bonds—and instead sell call options against their stock portfolio or buy funds that use this strategy. The buyers of these call options get the right to call away the underlying stock at a specified “strike” price either when the option expires or at any time up until the option’s expiration date. In return for that right, the buyers pay a premium to the sellers.

Selling call options has two key drawbacks. First, trading options is a zero-sum game: For every winner, there’s a loser. In fact, it’s less than a zero-sum game once you factor in the trading costs involved. As a seller of call options, you’re the winner if the underlying stock goes nowhere, because you make a little extra dough by pocketing the call premium. But you could end up as the loser if the stock climbs above the strike price. You might miss out on big investment gains—and the call premium you received may not come close to compensating.

That brings us to the second drawback. If you sell covered calls, you may see all of your good stocks called away and you might be left holding a bunch of duds. This could be more painful than you imagine. How so? Most years, the market’s performance is driven by a minority of stocks with strong performance, a phenomenon known as skewness. This shouldn’t be surprising: The most a stock can lose is 100% of its value, but the potential gain is unlimited. In many years, there will be a small number of stocks that score gains of 200%, 300% or more. If you write covered calls, your stocks that get called away could be among the market’s big winners.

Next: Asset No. 3: Cash

Previous: Unit Trusts

Articles: Options in Disguise, Risky Option and Got You Covered

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