i was doing some research on covered calls and came across your article you wrote a couple of years ago. i don't see where there is any down side. even though the profits might be small it appears to me that you will make some kind of money by writing a covered call. i understand that if the stock goes up i stand to lose money as the stock will be called away from me. my question is what are the risk of writing covered calls and is the risk limited or can i end up owing a bunch of money on a margin call or something like that... thanks for your help...

john

Hello John,

Covered call writing has some attractive benefits, but you are asking about the downside.

1) Profits are limited.

2) You do not always 'make some kind of money' when writing a covered call.  Yes, you always do better than the stockholder who does not write the call when the stock holds steady or declines in price, but you can still incur a substantial loss.  Assume you own a stock trading at 31 and write a call with a strike price of 30.  If the stock tumbles to 25, you are not going to make any money.  You do lose less than the other guy, but that is not 'making some kind of money.'

3) If the stock rallies above the strike price, you DO NOT 'lose money.'  You simply earn less than you would have earned had you not written the covered call option.  You earn a profit on the trade.  If the stock is called, you are simply selling stock at the price you agreed to sell it earlier (when you chose the strike price of the written call).

4) You CANNOT receive a margin call if you pay cash for the stock when you buy it.  Like any stockholder, if you use margin to buy your shares, you can get a margin call if the stocks decline rapidly and the value of your account shrinks.  But - you NEVER incur a margin call because you sold covered calls.

5) Risk is limited to that of any stockholder.  If the company goes bankrupt, you can lose it all.  But, I assume you are asking if covered call writing imparts a special risk.  The answer is no.

6) Under certain conditions you may fail to collect the dividend, if the stock pays one.

Mark

--
Mark D. Wolfinger
The Rookie's Guide to Options:
The Beginner's Handbook of Trading Equity Options
website:  http://www.mdwoptions.com
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