The Downside to Covered Calls

Covered calls are an awesome way to create income from stock that you already own.

For people who do not know what covered call options are, I'll explain them quickly here.

Writing Covered Call Options are when you collect money from someone, but that person bought the right to purchase your stock at a certain price (usually higher than it is today) between now and a certain date (when the option expires and can no longer be exercised).

It is a great way for the seller to make money on stock he or she already owns.

It is a great way for a buyer to stake a claim on stock (that he or she thinks will rise in price) for a price that WILL BE cheaper than at some point in the future BEFORE that option expires (and they lose the right to buy your stock at that certain price). They can get this claim for a cheap price.

Most of the time, these options expire worthless, because the price did not rise by a large enough amount quickly enough.

However, sometimes, the price spikes uncontrollably high. This is when the option BUYER wins.

The SELLER still collects the upfront money PLUS the profit, but he or she leaves the extra profit on the table. The other downside is that the seller is forced to sell shares of a suddenly rising stock. Perhaps, the biggest downside is that the seller will have to pay taxes on the profit, which is especially irritating when he or she has to sell the stock BEFORE owning it for a year.

Why a year?

That is when you get a cheaper tax rate on your profits. It becomes Capital Gains Income (currently 15%) instead of standard Earned Income (for most people--usually higher).