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Are “Covered Call” Option Strategies Really “Conservative”?

Are “Covered Call” Option Strategies Really “Conservative”?

Are “Covered Call” Option Strategies Really “Conservative”?

In the complex world of derivative investments, the attention of conservative investors is often drawn to a seemingly simple instrument: The covered call option.[1] Brokers and advisors often tout covered call strategies to their clients as “conservative” investment strategies, but this can be misleading.[2] A more accurate description might be to say that the strategy is relatively conservative. But relative to what? Well, options are derivative instruments, which means that their performance depends upon the performance of “underlying” stocks.  If the underlying stocks are risky, then writing call options on the stocks would reduce the downside risk of those stocks, but it would not necessarily make the investment strategy a conservative one when viewed in comparison to other investment strategies, like simply investing in conservative stocks or investing in a diversified portfolio of stocks and bonds.

A simple example helps to explain this point. Assume Investor A, Investor B, and Investor C are all retirees with conservative or moderate investment objectives. Investor A invests in a balanced portfolio of stocks, bonds, cash, and possibly some alternative investments. Investor B, meanwhile, invests 100% of his portfolio in stocks. Investor C also invests 100% in equities (the same equities as investor B), but Investor C writes call options on her stocks. Assume that a few years later there is a significant stock market crash. Investor A suffers losses in her equity allocation, but the losses are offset by gains in her bond and “alt” allocations. This is the benefit of diversification. Investor B is creamed because he has all of his eggs in one basket. Investor C does slightly better than Investor B because, although her underlying stock portfolio is also creamed, she at least has the premiums she received from selling her call options. Due to the magnitude of the market decline, the offset from the  premiums is insubstantial. So, in this example, we can see that the covered call strategy was “conservative” relative to the “naked” stock strategy, but not when compared to the diversification strategy.

Covered calls also come with inherent risks that may make them unsuitable for growth investors. What if the price of the underlying stock drastically increases? Normally, this would be the best scenario for the stock holder. But a call writer sacrifices his upside potential when he sells the call option.  The seller still receives some upside, but the call option places an artificial cap on an otherwise unlimited potential for gain.  The upside above the strike price now belongs to the buyer, and not the call writer.  This situation also has tax ramifications for the call writer as each sale is likely to result in capital gains tax.  What about the alternative scenario—where the price of the stock drops drastically? As described above, the call writer will collect the premium from their option, but there is nothing to prevent the underlying stocks from declining in value.  The stock could decline all the way to $0.  If the underlying stocks are speculative in nature, this is a distinct possibility. Many conservative and moderate investors fail to appreciate this risk because they rely on their broker’s or advisor’s unqualified reassurances that the call strategy is “safe” or “conservative.”[3]

Securities regulators have sanctioned brokers for sending “inaccurate, misleading and unbalanced communications” relating to covered call options. In one case, the SEC upheld disciplinary sanctions imposed by FINRA against a broker who advertised a “collar option” strategy as “safe” and failed to “mention that the strategies . . . involved the risk of substantial losses should the value of the underlying security significantly change.”[4] In the Matter of the Application of William J. Murphy, SEC Admin. Proceedings File No. 3-14609. The SEC concluded that the broker knew or had reason to know that his communications were “misleading.” The sanction imposed by FINRA and upheld by the SEC, which stemmed from various other violations as well, was a lifetime ban for the broker and a restitution order for more than $500,000.

If you have suffered substantial losses in your investment portfolio as a result of options trading strategies, including so-called “conservative” options-trading strategies, you may have a claim against your brokerage or advisory firm. Contact our firm to set up a free consultation with an experienced investor advocate.[5]

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[1] To understand the covered call, one must first understand a basic call option.  A buyer of a call option purchases the right—though not the obligation—to obtain a number of shares in a particular stock from the seller (a.k.a. “call writer”) for a pre-agreed price (the “strike price”).  The buyer will exercise that right if the value of that underlying stock exceeds the strike price.  Regardless of whether or not the buyer exercises its right, the seller will collect a premium from the buyer.  This is how the seller profits from the arrangement. A covered call, by extension, is when the seller of a call option actually has the shares to deliver in the event that the buyer exercises the call right.  This “covers” the seller, limiting their downside risk in that—if the buyer does choose to exercise their right—the seller will not have to obtain the shares necessary to honor their agreement on the open market, which could be at a devastatingly high price.  If you do not already have the shares of stock to back up writing (selling) call options, this is intuitively called a “naked” option.

[2] Most brokerage firms permit their brokers to engage in covered call strategies with unsophisticated investors, despite the fact that many of those investors do not fully understand the nature of their investment. In addition, many brokers use covered call strategies as a “gateway” to lead their clients into more speculative areas of options investing.

[3] Long-term investors may be somewhat protected if they have the ability to wait out the stock’s decrease in value but short term investors might not have that luxury.  Even long-term investors could find themselves in need of liquidity, which could mean selling the stock at a devastating loss.

[4] A “collar option” strategy incorporates a covered call strategy and adds another strategy, known as a protective put. It is arguably a more “conservative” strategy than a covered call strategy.

[5] Contributory credit for this blog post goes to William Cort DiSessa, who is currently enrolled at Michigan State University College of Law and is a student clinician is the MSU College of Law Investor Advocacy Clinic.