Let’s move on to some disadvantages.
Option Disadvantage #1: You Have To Work In “Round Lots”
Ordinarily share price does not matter, but with options it makes a difference. One contract is equal to 100 shares, or a “round lot.” So if you want to sell a covered call you have to first own 100 shares.
For something like CSX Corporation (NASDAQ:CSX) that’s a $2,600 commitment, definitely manageable. For something like Alphabet Inc (NASDAQ:GOOG) owning 100 shares would mean a $70,000 commitment. That’s a little less realistic for the average investor. Options can be limiting in this way.
Option Disadvantage #2: Options Can Cap Your Upside
The essence of a covered call is that you do better (return wise) when the option is not exercised, but you “cap your gain” when the option is exercised.
As illustrated above, if shares of Target jumped to $100 you would have put in this extra work to learn about options and figure out what agreement you would like only to do “worse” than a buy and hold investor. This is why it’s so important to be content with the selling price that you agree to.
Option Disadvantage #3: Options Could Make It More Difficult To Own Shares In The Future
If you truly want to own shares in a company for the long-term there’s no better way to do it than to simply… own shares.
Continuing with the Target example, if shares jumped to $100 you would have capped your gain and be forced to sell at $95. You might be happy with this agreement, but the share price bids could keep going up through the years never to return below $95 again. As such, it could become more difficult (i.e. you have to pay more) to “get back” those shares should you want to do so in the future.
Option Disadvantage #4: Have To Redeploy Capital
Personally this is the fun part for me, but for a lot of people they like to have a passive “set it and forget it” approach.
The likelihood of having to redeploy capital increases dramatically by selling covered calls. Naturally you have additional premiums to redeploy, but more pertinently your shares might be sold. This part is mitigated a bit by only agreeing to prices that you’re happy with, but it remains that eventually you could have to figure out what to do with thousands of dollars at a time.
Option Disadvantage #5: Separate Tax Implications To Think About
Finally, there are tax implications to think about that go beyond a basic buy and hold strategy. For one, the option premium can be taxed at ordinary rates (short-term gain) instead of preferential rates as is often the case with qualified dividends.
Further, selling in the future could also trigger a taxable event. There are some somewhat complicated rules around various situations, but basically the likelihood of short-term gains increases.
This sounds like bad news, but I don’t believe it should drive an investment decision. In the above example you might pay ordinary rates (but not necessarily) on the ~$110 option premium to start. This is in comparison to paying 0% and an extra $0; so it’s all relative. From there, future tax implications depend on your cost basis of the security, length of time owned and whether or not the option is exercised. This too goes beyond the scope of an introduction, but the added complexity is nonetheless a downside for some investors.
Final Thoughts
That’s the basic overview for becoming aware of selling covered calls. A lot of dividend investors focus on finding the best businesses, partnering with these companies at reasonable valuations and holding for years as the dividend income begins to stack up. This process can work quite well and indeed it is something that I have long advocated.
However, that’s not to suggest that it’s your only alternative.
If you’d like to both own shares of excellent businesses and derive more cash flow, here’s a way to do so. By making an agreement to sell at a price that you’re happy with you’ll receive an upfront premium. Your total returns may be better or worse than simply holding shares, but the cash flow component is apt to be higher. The idea is to learn about the process and determine whether or not it might help you to achieve your investment goals.
Disclosure: This article is originally published on Sure Dividend by Eli Inkrot.
