Many options traders view the covered call as a safe strategy. But are they right?

The combination of premium income, dividend, and capital gains is quite appealing, without doubt. Selecting the right contract yields double-digit annualized returns. But there are risks. The covered call is not a risk-free strategy, so anyone going into one should be aware of what they face.

Here are some points to keep in mind:

  1. Downside risk. The covered call provides limited downside protection because the call's premium reduces your basis in stock. However, if the stock price falls below the net basis (cost of stock minus premium income), you have a paper loss. At that point, what can you do?

First, you can close the call and take a profit. The call should be worth less than the price you got when you sold, so your buy to close order yields a net profit. But then what? If you write another short call with a lower strike, are you willing to take a smaller capital gain upon exercise? This depends on your original basis in the stock.

Also, you can double down - buy more stock and sell another, lower-strike call. In this case, the strike should be less than the combined basis in stock, but this will be lower than on the original position. This occurs because with declined stock price, your overall basis is also reduced.

  1. Accurate yield comparisons. Shorter-term covered calls produce better yields than longer-term calls. This occurs because time decay is more rapid as expiration approaches. So writing six 2-month calls over one year will produce better net returns than writing one 12-month call.

Calculating annual yield is always wise when comparing one short call to another. To annualize, first calculate the return. The most consistent method is to divide premium received by the strike. Second, divide the return by the holding period (in days or months). Finally, multiply the result by a full year (365 days or 12 months) to arrive at the annualized return. This is useful for comparison, but not necessarily as an assumed rate you will earn throughout the year.

  1. Uncovered short put, an alternative. The short put has the same market risk as the covered call, but the comparison is complicated by several factors:

-- for an uncovered put, you have to deposit collateral equal to 100% of the strike. For example, with a strike of 45, you must maintain a balance in your margin account of at least $4,500. In comparison, for a covered call, you can buy shares of stock and pay only 50%, with the balance bought on margin.

-- with a covered call, you earn dividends, and with an uncovered put, you do not.

-- if the stock price declines below the basis of a covered call, you have to wait out the market or enter into a recovery strategy. With an uncovered put, you can roll forward to any strike without concern for strike value, since you have no offsetting stock.