TRADING

Covered Calls: Are These 3 Beginner Mistakes Costing You?

How to recognize and avoid these common mistakes.

Erik Bassett

--

Photo by Austin Distel on Unsplash

Covered calls are safe and simple. Whether alone or as part of the wheel strategy, they’re one of the best ways to trade options profitably.

But throw just a little haste or surplus risk in the mix, and your profitability vaporizes in a hurry.

After roughly a year of trading covered calls myself, and studying how others do the same, here are the mistakes I’ve made or consistently seen:

  • Using high premium to justify buying stocks you’d otherwise consider too volatile to hold
  • Setting strike prices too aggressively, thus trading long-term appreciation for heavily taxed) short-term premium
  • Selling at inopportune times when you ought to wait instead

I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.

Chasing volatility

Volatility drives premium, and premium drives covered-call newbies into bad positions.

Take two firms trading at $50: one blue-chip that has barely budged in weeks, and one hot IPO that’s bouncing all over the place. If you sold next Friday’s 0.40-delta call on each, it might it bring in $40 on the blue-chip versus upwards of $150 on the trendy start-up.

Newbie Nick has the cash for a $5000 buy-write position (i.e., buying the shares and writing the call at the same time), so he thinks, “Perfect! I’ll take the start-up every time and make like 75% a year just on premium! What could go wrong?”

Well, by the very fact of such a high premium…a lot could go wrong.

Nick is forgetting that high premiums reflect high chances of a huge upswing (which he’ll miss out on) or a huge downswing (which will cost him much more than $150). For that matter, both could happen in the course of a couple months.

It feels nice to collect the hefty credit, but nine times out of ten, Newbie Nick will regret chasing premium into that position.

What to do instead

If the stock weren’t optionable, would you still buy it?

If not, then there’s a very good chance your money belongs elsewhere. Again, call premiums are awfully nice, but so is not watching your equity evaporate (or, almost as painfully, take off to the moon without you).

Cutting off too much upside

It’s tempting to sell near-the-money calls to maximize premium. And that strategy does make sense if you’re bearish on the stock right now but still believe it the company as a long-term holding.

But you might have noticed it’s uncannily easy to sell them right when that stagnant stock starts rising. Depending on the magnitude of the move, your opportunity cost (from assignment) maybe be several times the premium received.

Hypothetically, Newbie Nate might have sold a $51 call (at a $50 share price) for $90 in premium. The $53 call would have gotten only $40, and Nate wanted more cash now.

The problem is twofold.

The first aspect is opportunity cost. Gaining that extra $50 in premium meant sacrificing $200 in potential upside. He’s $200-$50 = $150 worse off than he could have been. To be sure, that’s just an opportunity cost and not an actual loss. But he now needs multiple calls to expire worthless just to catch up to where he could have been.

Now, hindsight is 20/20 and Newbie Nate might have had good reason to think that was the right play at the time. But if he continues trying just to maximize premium come what may, then his returns will probably lag.

The second is taxation. Near-the-money calls will result in frequent assignment—unless the stock never rises much, which is a whole other problem! Unfortunately, that means every single sale will be taxed at the higher, short-term capital gains rate.

Of course, it’s still a profit. And the tax treatment might not even matter to you. But it’s still a disadvantage worth thinking about as you’re choosing strikes.

What to do instead

Remember that this is a long-term game. If it’s an exceptionally low-volatility period, simply accept that call premiums will be lower than you’re accustomed to.

It’s better to collect a bit less for a few weeks or months than to create an opportunity cost or a tax situation you weren’t really OK with.

Selling calls impatiently

There’s no sense selling a call today just because, well, you can.

Related to the previous point, Newbie Nick could probably get more premium by simply waiting for an upswing before selling his calls.

That’ll let him a) sell farther out of the money for the same premium or b) sell a similar distance out but for a higher premium.

It would also spare Nick that why-oh-why?! feeling when the stock finally makes an overdue upward move the day after he sells the covered call.

Hey, we’ve all been there…

What to do instead

Premiums can increase substantially following just a 1–2% share price increase, even without a major trend or news event. (Of course, volatile assets will need to move more sharply to have a same effect.)

Don’t use this as an excuse to yield to the temptations of chasing volatility or selling too near at the money just to eke out more premium today.

But most of the time, it’s worth a little wait.

Meanwhile, remember that waiting isn’t some sort of defeat. Deliberately doing nothing is a strategy, and sometimes it’s the right one.

Simple tips for simple profits

Don’t worry if you find yourself making similar mistakes at first—and speaking from experience, you will make some.

Likewise, don’t fret if a covered call position doesn’t go as planned despite everything checking out on paper. Surprises happens, plain and simple. If the market were literally foolproof, there wouldn’t be any surplus returns!

Despite these classic pitfalls, covered calls are a terrific part of both short- and long-term investment strategies. And the better you understand their mechanics and your own tendencies, the smoother sailing it’ll be.

--

--