Why Covered Calls Are Bad

We get asked all the time why covered calls are bad. We want to be clear – they’re not inherently bad, but there are some downsides to be aware of:

1. You limit your upside potential in the long position. Should the stock price climb above the strike price and the option gets exercised, you miss out on additional gains.
2. Despite collecting premium, you could end up seeing a loss on the trade if the stock’s price plummets.
3. The actual process of implementing this options trading strategy can be quite complex, especially for new beginners.

That’s not to say you should avoid selling covered calls, though. You can overcome these challenges simply by using the VectorVest stock software paired with OptionsPro. This helps you pick the right stocks and configure your covered call contracts to maximize your premium without exposing you to unnecessary risk.

Key Takeaways on Why Covered Calls Are Bad

• Covered calls can be bad because they cap your upside, and premiums don’t protected against real losses. Taxes can eat into returns, while assignment disrupts long-term plans in some cases.
• You can avoid a lot of these risks by executing a smart strategy with VectorVest. Our software tells you what stocks to choose, and the OptionsPro integration helps you stack the deck in your favor.
• You have other options if you decide after reading our guide on why covered calls are bad, options like dividend-stock investing, cash-secured puts, and ETFs/growth funds are worth looking into.

What Are Covered Calls?

This options strategy involves two main actions: holding a long position in a stock and selling (writing) call options on that same stock.

You can generate income through the premiums received from selling the call option. You could also benefit from stock appreciation – at least, up to a certain point. There are two components of the options contract:

• The Strike Price: The predetermined price you’ll set when creating your contract that influences the premiums you earn. A wider spread between current stock price and the strike price means it’s less likely the contract will end up in the money (which is good from the sellers perspective) – but it also means you’ll earn lower premiums as the buyer is taking on more risk.
• The Expiration Date: The longer timeframe your contract is open, the higher premiums you’ll collect as you’re giving the buyer more opportunity to end up in the money. However you’re also taking on more risk as the seller.

There is a balancing act between setting strike prices and expiration dates that boost your odds as a seller and capturing premiums that make it worth it. Either way, here’s a quick overview of how selling a covered call works:

1. Hold the Stock: You own at least 100 shares of a stock (options contracts work in lots of 100).
2. Sell Call Options: You sell call options against those shares, agreeing to sell the stock at the strike price if the buyer exercises the option.
3. Receive Premium: You receive a premium for selling the call option.

There are two potential outcomes. If the stock price stays below the strike price, the options expire worthless, and you keep the premium.

On the other hand, if the stock price rises above the strike price, the buyer may exercise the option, at which point you’re required to sell the stock at the strike price. You may still end up profitable, but you miss out on potential income above the strike price.

Why Covered Calls Are Bad

It’s clear that covered calls present a compelling opportunity. However, it’s essential to understand the risk of selling covered calls as well. Let’s get into why covered calls are bad in some cases below.

Limited Upside Potential

The biggest risk of selling covered calls is opportunity cost. You’re placing a limitation on your upside potential compared to simply maintaining a long position in the stock.

When you sell a call option, you agree to sell your stock at the strike price if the option is exercised. This means that if the stock price rises significantly above the strike price, you miss out on those additional gains.

For example, if you sell a covered call with a strike price of $50 and the stock price rises to $60, you are obligated to sell at $50, thereby capping your profit. If you bought the stock at $45 you still profit $5/share along with the premium earned, but you’ll miss out on that additional $10/per share profit.

Tax Implications

Taxes on options trading are already complex to begin with – but they can become even more convoluted when selling covered calls, and that’s why covered calls are bad, too.

The premiums received are considered short-term capital gains, which are taxed at a higher rate than long-term capital gains. Plus, you may have to pay taxes on any capital gains from the sale of the stock if your stock is called away. This can complicate your tax situation and potentially increase your tax liability.

Risk of Assignment

The buyer exercising their option doesn’t just create opportunity cost problems in the form of limited upside potential – it could interfere with your portfolio-building strategy in other ways.

Say you’re investing in dividend stocks for Roth IRA. If you’re forced to sell your position you’ll then run the risk of missing out on upcoming dividend payouts, which you may have been counting on as a source of income.

Sure, you could simply re-purchase the shares after selling your previous position – but in some cases, it won’t make sense if the stock has risen to the point it’s now overvalued. You’ll be stuck waiting on the sidelines for a better opportunity to buy.

Potential for Loss

So many new options traders make the mistake of thinking that selling covered calls protects them from losses – this is not true. It only mitigates losses to a certain point.

The premium will offset some level of loss, but likely not all of it in the case that the stock price plummets. Say you have a 100-share position in a stock that sits at $40/share, and you sell a covered call, collecting $100 in premium. If that stock falls to just $30/share, you still end up losing $900 on your position.

It’s worth noting that the risk of stock price drops exists across any strategy, though. This isn’t unique to why covered calls are bad.

Are Covered Calls Safe When You Have VectorVest in Your Arsenal, Though?

You can avoid many of the risks we discussed simply by leveraging a proven stock trading system in VectorVest: the best iPhone stock app ever created.

It’s a proven approach that has outperformed the S&P 500 index by 10x over the past 20 years and counting. It can help you streamline how to find stocks for options trading while offering you insights on strike price and expiration date configuration that tip the scale in your favor.

Proven Guidance in Choosing the Right Stocks

VectorVest is the best stock picking app because it tells you what to buy, when to buy it, and when to sell it at just a glance, saving you time and stress while empowering you to win more trades.

It takes complex technical and financial data and distills it into clear, actionable insights through 3 simple ratings: relative (RV), relative safety (RS), and relative timing (RT). Each is placed on a scale of 0.00-2.00, with 1.00 being the average, making interpretation quick and easy.

Buy beyond giving you a buy, sell, or hold recommendation for any given stock at any given time, you also gain access to a world of possibilities with pre-configured stock screeners. You never have to look far for your next trade, whether you’re looking for low-volatility stocks for options trading or aggressive growth stocks.

Stacking the Odds in Your Favor With OptionsPro

When it comes to selling covered calls, or trading options in general, pairing our stock advisory with OptionsPro dramatically increases your odds of success.

This suite of tools helps you scan a list of tools and pinpoint those that offer the highest probability of profits, regardless of whether you’re selling or buying options.

You never have to stress about when to sell options or when to exercise options again, either. Specialized theta decay charts show you the perfect moment to make your move either way.

Meanwhile, a unique options implied volatility study helps you determine whether an option is overpriced or undervalued, so you can steer the odds in your favor.

There is even a Sweet Spot calculation that shows you the specific point at which you’ll earn maximum time premium before time decay starts to creep in. This helps you win more often and enjoy quicker profits along the way.

Configuring your options contract becomes effortless as you can look at a skew of strike prices, showing you which offers the best potential for premium in conjunction with expiration dates.

If you’re getting started with stock options for beginners, we believe this is an essential tool in your arsenal to avoid the risks of selling covered calls and stacking the deck in your favor.

But don’t just take our word for it – get started with the best stock research website and see how much simpler things can be with VectorVest!

What Can You Do Instead of Selling Covered Calls?

Even with VectorVest, you might decide that selling covered calls feels too restrictive or complex. There are plenty of alternative strategies that can help you generate income or manage risk without capping your upside, such as:

Buy Dividend-Paying Stocks

This could be a simpler and more predictable path if your goal with covered calls is steady income. You aren’t limiting your upside, and you can still benefit from price appreciation. Look for companies with strong cash flow, low payout ratios, and consistent dividend growth.

Sell Cash-Secured Puts

This strategy works as a counterpart to covered calls. Instead of owning a stock and selling a call, you set aside cash to buy a stock at a lower price by selling a put option.

If the stock doesn’t drop to your strike price, you keep the premium. If it does, you buy the shares at an effective discount. It’s a low-risk way to get shares of companies you already want to own.

Use Protective Puts to Limit Downside

A protective put may be a better fit if your main concern is protecting gains while maintaining upside. You buy a put option on a stock you already own, creating a safety net if the price drops. It costs more upfront, but you get insurance without restricting your profit potential the way a covered call does.

Invest Through ETFs or Growth Funds

Maybe you don’t even want to manage individual contracts. There’s another option. Broad-based ETFs focused on dividend income or growth stocks can produce similar returns to a covered call portfolio with way less oversight. Look into funds like SCHD, VIG, or VYM.

Wrapping Up Our Guide on Why Covered Calls Are Bad

There you have it – why covered calls are bad. That is, without VectorVest. You could be limit your upside potential, create tax challenges, mess up your portfolio, or deal with losses.

At the end of the day, though, you could find drawbacks for any investment strategy. Covered calls are not unique in that they carry some level of risk. The question is, does the risk outweigh the reward, or vice versa? Only you can decide.

VectorVest is an essential ally for any investment strategy, but specifically options trading. So, get a free stock analysis today, or start your trial and discover firsthand why the most successful options traders use VectorVest!

Frequently asked questions

What is the downside of covered calls?

The biggest reason why covered calls are bad is you limit your upside potential. if the stock price rises above the strike price, your profit is capped. You also risk losing money if the stock falls sharply, as the premium collected won’t fully offset losses.

What is the success rate of covered calls?

Most covered call strategies show a high “win rate” in stable markets – often 60-80% – because options expire worthless and you keep the premium. But they can drop sharply during volatile or bullish surges when prices move beyond your strike.

Can I lose money selling covered calls?

Yes. The premium does help cushion losses, but a large drop in the stock price can still lead to significant losses. You’re exposed to downside risk just like any long-term shareholder.

Why are covered calls a bad strategy?

They’re considered “bad” when used incorrectly, mostly because they cap gains and offer limited protection. They don’t have to be bad, though. You can avoid a lot of the risks with VectorVest.