A covered call consists of two components, long stock and short call (e.g. buy 100 shares of stock and sell 1 call option). Let's look at both to see where the risk is.
When you sell a call option you receive cash in the form of option premium. This option premium is yours to keep whether the option expires worthless or is exercised. As long as the call option sold is above the cost basis of the stock, such that it will result in a profit if exercised, then there is no risk in the call option.
So, if there's no risk in the call option that must mean that all the risk is in the stock. The risk in the stock is a major price decline and/or company bankruptcy. This is no different than a buy & hold strategy, where again all the risk is in the stock. So, covered calls are no more risky than buy & hold.
Now that we know that all the risk is in the stock, how do we minimize that risk? Two methods that I use are stock selection and position sizing.
For stock selection, I basically use the methods described in Pat Dorsey's book "The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market"
. Mr. Dorsey is the Director of Stock Analysis at Morningstar. This is a value investing approach. I look for companies that generate positive earnings, free cash flow, have good return on equity and low debt. I use Morningstar to find these companies and then run the stocks through Value Line Daily Options Survey (I previously used PowerOptions) to find potential covered call trades.I don't believe that any type of analysis has any relevance on future stock prices. I'm only concerned with the current price at the time I buy the stock and whether or not the stock is overvalued or undervalued. I believe if you buy an overvalued stock there's a greater risk of that stock declining. My goal with trying to find undervalued stocks is to reduce the risk of a major decline. Also selecting good solid companies reduces the catastrophic risk of a company bankruptcy, which is the biggest risk in covered call trading.
I also don't believe in just picking the stocks with the highest covered call return. Premiums are usually high for a reason and usually event driven. This is especially true for biotech and pharmaceutical companies.
The second method I use to minimize risk is position sizing. Covered calls, just like buy & hold, have a limited risk, since a stock can only fall to zero. Granted, this would result in a 100% loss, but that's the most you can lose (i.e. it has a limit) and the likelihood of a stock going to zero is very low.
I use a position sizing limit of 5% or less of total capital. For example, if I had $100,000 of total capital my position size would be limited to $5,000 per stock. Now, if a stock's price was $50.00 I could buy 100 shares, and if it was $10.00 I could buy 500 shares. However, I limit all my initial positions to 100 shares. This gives me room, in most cases, to buy additional shares (dollar cost averaging) should the stock decline after I purchase it.
So, by selecting solid companies trading at or below their fair value and limiting the position size I potentially minimize the risk to my portfolio. However, this is still no guarantee that a stock won't decline, but that's where my position management strategy kicks in. By having a plan, I know what to do ahead of time, so when the eventual decline happens, and it will happen, I'm prepared for it and don't panic.
Another form of risk in trading covered calls is lost opportunity risk. If the stock's price soars far above the strike price of the call, then the call will most likely be exercised and you'll be forced to sell the stock below the current market value. In this case you would have done better with a buy & hold strategy.
As you can see from some of my past trade examples this has happened, however, I'm not concerned about lost opportunity risk. How many stocks are likely to soar? It happens, but not that often. When you compare the certainty of short term returns from writing covered calls to the risk of losing potential capital gains on appreciated stock price, you'll see that the consistency in writing covered calls produces better risk adjusted returns.
As long as I meet or surpass my return goals, I'm satisfied. That's why it's important to set return goals and have a means to measure them, in addition to managing risk. If you don't know where you're going, how will you know when you get there?
