Most naive options traders unwittingly commit a fatal mistake when they trade covered calls. Seemingly innocuous, this mistake ensures guaranteed losses to your trading account—even if you believe you are being cautious. Covered calls have inherent characteristics that make them seem like a recipe for generating steady cash flow, but what they also share in common is the hidden pitfall that ensures even the seasoned trader gets caught with his pants down. Result? A disastrous outcome that will ensure all your gains get reduced to zero and puts your account in the red.
In this article, we explain how covered calls work, what the fatal mistake that most traders make is, and how professional options traders mitigate those. By adopting a thoughtful approach and readjusting your strategy, you will not incur absolute loss but generate steady returns in the long run.
How Covered Calls Work
A covered call is actually an options strategy wherein a trader buys shares in a stock and, simultaneously, sells call options for the same stock. The call options give the buyer the right to purchase the shares at a set strike price. If the stock price exceeds the strike price, the buyer will exercise the option, and you, being the seller, will be obligated to sell the shares at the agreed price.
For example, buying 400 shares of Nvidia for $123.62 and selling four call options at a $124 strike price is a covered call position. So now you have a reduction in your capital investment that you had made, but here’s the catch: when Nvidia’s stock price shoots up and skyrockets, you are obligated to sell your shares for $124 irrespective of how high your share price goes.
The Fatal Mistake: Selling Calls at Below Acquisition Price
The most egregious options trading mistake that covered calls involve is selling call options at a strike price below the cost of acquiring stocks. This might seem like an easy way to collect extra premium income, but if the bounce arrives, you’re stuck selling at the strike price and ensure your painful loss on your shares. This can quickly turn a potentially profitable strategy into a lost cause.
Example of the Incorrect Strategy
Let’s consider Nvidia stock. Now it’s your first profitable covered call trade. You decide you want to cover 400 shares at $129.24 and sell call options with a strike of $114. This is where things are going wrong. Nvidia’s stock could even rally, and if it hits over $114, you are obligated to sell them at $114. Since you paid $129.24 per share to buy the shares, you would lose more than $15 per share. The premium you might collect when selling the calls would not even come close to offsetting this amount of loss.
Why This Is a Sure Loss
When greedy traders start thinking only of how to collect the most premium they can by selling calls at the cheapest strike price, they are going to lose good money if this stock bounces back. This would mean that all the profit made from premiums collected during the trade would be wiped out. In the long run, you will draw your account down.
The basic problem here is that the options market is pretty volatile, especially with high-growth stocks like Nvidia. And therefore, although the premium you collect from selling calls appears juicy in the short term, you could end up selling below your acquisition price if the stock rallies. That way, you guarantee the loss.
The Professional Approach: Do Not Sell Calls Below Acquisition Price
Professional options traders make covered calls much more conservatively since they never sell calls below their acquisition price. This may bring in lower premiums, but it reduces the possibility of locking in a loss if the stock price bounces back significantly.
Example of the Right Approach
Let’s remember the Nvidia example but do it this time in a more accurate way. When shares of stock at $129.24 are purchased, a professional seller wouldn’t sell any call options for less than what he or she bought them. Thus, he or she sold all the call options above the $129.24 he or she paid for them. If the stock happened to fall to $113.06, then selling calls at a strike price of $114 would not be materialized. Instead, they’d sell at the $130 strike price.
While this premium is lower (some $0.47 per option), the trader does ensure that they cannot be pressured to sell below their cost. In this example, if Nvidia runs higher, then at worst, their shares would be sold at $130, a respectable number over their acquisition price, with no loss on the shares themselves.
Long-Term Benefits of a Cautious Covered Call Strategy
This disciplined approach can be labeled as rather conservative, yet it ensures that you can produce income that is steady without sending your account to excessive risk. By selling calls at or above your acquisition price, you rule out the possibility of having to sell your shares at a loss if the share price rises. Over time, this strategy ensures that you can remain in the game and trade profitably without continually threatening the loss of your account.
This mindset prepares traders to better ride the ups and downs of high-growth stocks like Nvidia.
Conclusion
Covered calls can generate a nice stream of income, but only if done correctly. The most egregious mistake naive traders make is selling calls at strike prices that are lower than their purchase price. This strategy assures you of taking a loss if the stock price happens to move up. Always sell calls at or better than your purchase price. That way, you eliminate the possibility of losing if the stock price surges, and covered calls will consistently help you in your quest for long-term profitability.
