While the covered call strategy sounds like a clever way to supplement return with income, there are two major risks associated with it: one on the upside and one on the downside.
The first risk is on the upside. If the markets take off too quickly, the call option goes in-the-money. Under such circumstances the portfolio manager really only has a few options:
- he could close out the trade and take a loss on the option trade;
- the underlying asset could be called away and miss out on the gains;
- the portfolio manager could cross his fingers and pray that the stock reverses direction and dips back below the strike price before being called.
Regardless, the covered call has effectively sold off its upside potential in a sharply rising market.
The other risk is on the downside. A covered call strategy offers no downside protection. The long position is unhedged and completely exposed to losses. The income from the sale of calls might offset a bit of the losses, but in a situation where the market sells off 20%, 30%, 40% or more, it is highly likely a covered call strategy would face similar losses.