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Know Your Potential Risk in Covered Call Trades

The greatest source of risk in a covered call trade is the stock you own in the trade.  Losses are almost always the result of a price decline in the stock or the overall market.  Here is a list of primary risks in covered call trades.

  1. Decline in the stock’s price forces the trader to make adjustments.  This can happens to anyone but rarely happens with disciplined stock selection.  This is why you want to stay with safe stocks with great fundamentals.
  2. Traders fall into the assignment trap when a stock pulls back and they write calls at a strike price below their cost basis.  Then, when the stock recovers the trader will be assigned at a loss or buy back the calls.
  3. The trader will roll up to a higher strike price when a price spikes only to see the price backup to previous levels.  This will increase the cost basis as you paid more to buy back the short call than you received in premium.  You must first determine that the stock price will hold the new higher price before making this move to roll up.
  4. When the trade changes, traders want to add on options to grab more profits or to hedge their position.  These types of strategies should only be done by the experienced trader with knowledge of how add ons change the trade dynamics of risk.

All of these risks can be linked to the trade discipline or lack of discipline in the heat of the moment.  How many times have you seen a stock price spike one day and then pull back over the next few days?  this happens all the time so the trader must be disciplined not to immediately over react without confirmation of the move.  For experienced traders, they know how to determine if the price move is for real and when to make the right trade adjustment.

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