Of course, everyone has heard that disclaimer at the end of every investment commercial and from your brokerage;
‘Investing involves risk. Investing is not suitable for all individuals. May lose all of the principle invested.’ …Or something to that effect.
So it goes without saying that if you want to sell covered calls you’re always at risk of losing money. Especially if you fail to watch your positions. That being said, the question still remains; can I lose any money if I decide to write covered calls?
Is it a perfect strategy?
Let me be the one to tell you. If you’re looking for the magic bullet strategy of the stock market, it doesn’t exist. And if anyone tells you that it does…watch your wallet closely.
The question you’re really asking is, “are covered calls risky?” That’s not the same as asking if the covered call strategy is one that can lose money.
What you’re wondering is “if I invest in covered calls am I going to lose my shirt’ isn’t it?” Even a well executed covered call trade has the potential for loss if the stock doesn’t perform to your expectation.
The loss most people refer to is the loss of profit. Take notice though, loss of profit and losing money aren’t necessarily the same thing.
Loss of profit v. losing money
Losing money means that whatever principle you have left after you closed out the position is less than what it cost to enter the trade initially. Basically, if it costs you $1,000 to open a position and you close it out for $900 then obviously you lost money.
However, if you closed out that same position for $1,100 then, of course, you made a nice $100 profit. So what does that have to do with losing profit?
A loss of profit is one of the tradeoffs for implementing the covered call strategy. What you gain in consistent, conservative income you give up in income potential.
What exactly do I mean when I say income potential?
How to calculate when you will lose money.
Say you bought 100 shares of stock at $20 each. You then sold a covered call contract at the strike price of $22.50. By selling the covered call, you give someone the right to buy your stock for $22.50 per share regardless of the current price of the stock.
Fast forward to expiration.
The price of the stock at options expiration is $24. Since you sold the covered call at the $22.50 strike, you’re obligated to sell your shares for $22.50 each. Even though the current price of the stock is $24.
In this scenario, you’d lose out on extra profit because of the covered calls you sold. Had you not sold them, you’d potentially be able to reap a $4 profit per share since you bought them for $20.
There can also be a loss on this strategy if you were to sell a call option at a strike price lower than what you paid for the stock.
I mentioned earlier that any stock market strategy has the potential to lose money. Let’s figure out exactly when that can happen.
This is the formula that tells when you will officially start to lose money. It may also be a great time to get out of that position.
Using the same example above where you bought 100 shares for $20 each, say you again sold one covered call contract. Again you sold the contract at the $22.50 strike. For this example, the month doesn’t matter.
The premium received for the sold call is $50 or 50 cents per option. Commissions are also being left out for the sake of simplicity.
Your first calculation when you buy anything should always be your break even point. To get your break even just follow this equation;
Stock purchase price – premium received = Break Even.
Let’s plug in the numbers from our example to get this break even.
You purchased the stock for $20 per share. Then sold a covered call for $50 ($0.50 per option) Our break even is $19.50. Once the stock gets below $19.50 per share you begin to lose money.
$20 – $0.50 = $19.50.
To keep from getting confusing numbers, always use the price of a single share of stock and the per option price to calculate your break even.
This is the simple version. But not necessarily the practical version.
What if I’ve sold multiple covered calls?
If you’ve had those shares for a year and you’ve successfully sold covered calls each month, your break even is actually different.
I’d like to first point out that you should always figure out your break even on each and every position. Doing this before you enter any trade puts you in the best position to manage your capital efficiently.
Say you’ve sold six covered calls over the course of the year. And you made $50 on each one. That would mean you made $300 that year from writing covered calls.
This also means you have reduced your cost basis or your initial cost of buying the shares of stock.
Buying those 100 shares for $2000 made you $300. Which means you decreased your cost by $300. Your true cost of the shares you own is actually $17.00 per share.
As you continue to make successful covered call trades, you increase your profit and gradually decrease your cost basis.
If at the beginning of the next year, you have a covered call trade that results in a loss, that doesn’t really mean you are at a loss for your entire position.
It just means that particular trade is a loss. When a covered call ends up being a losing trade, you need to evaluate the fundamentals and technicals. Why?
You thought the stock was going to stay flat or slightly increase right? The stock price would have had to decrease in order for it to result in a loss.
Checking the charts could be the first place to tell you the stock should no longer be in your portfolio.
Remember, people choose covered calls because they are considered to be less risky than other investing strategies. Not because it’s guaranteed money.
The only guarantee is you. If you know your break even before you place a trade, you’re one step closer to making money with covered calls. And further away from losing any of your hard earned money.