Why Covered Calls Can Be Bad Risks When To Avoid Them

Selling covered calls is often marketed as a conservative, income-generating strategy for stock investors. While it can work well in certain market conditions, it's far from risk-free. Many investors jump into writing covered calls without fully understanding the trade-offs, only to discover too late that they've limited their upside, locked in losses, or misjudged volatility. The reality is that covered calls carry nuanced risks that can turn profitable strategies into costly mistakes—especially when used at the wrong time or with the wrong stocks.

This article breaks down why covered calls can backfire, identifies high-risk situations where you should avoid them, and offers practical guidance for making smarter decisions about when—and when not—to use this popular options strategy.

Understanding the Covered Call Trade-Off

A covered call involves owning 100 shares of a stock and selling one call option against it. In exchange for receiving a premium, the investor agrees to sell the stock at the strike price if the option is exercised. On the surface, this seems like a win-win: collect income while holding a stock you already own.

But the trade-off is asymmetric. The seller gives up all gains above the strike price in return for a limited premium. If the stock surges past the strike, the investor misses out on significant appreciation. This capped upside is the core structural limitation of the strategy.

“Covered calls are like renting out your house with a pre-set sale price. You get monthly rent, but if property values skyrocket, you’re still obligated to sell at the old price.” — James Adler, Options Strategist at MarketEdge Capital

The premium received rarely compensates for large upward moves. For example, selling a $50 strike call on a $48 stock for $1.50 may seem smart—until the stock jumps to $60 due to an earnings beat or acquisition news. The investor earns $1.50 but forfeits $10 in unrealized gains.

When Covered Calls Become Risky

Not all stocks or market environments are suitable for covered calls. Below are five high-risk scenarios where the strategy can do more harm than good.

1. High-Growth or Momentum Stocks

Using covered calls on fast-moving stocks like tech innovators or emerging market leaders is inherently dangerous. These stocks often experience sharp rallies on positive news, rendering the call option deep in-the-money and triggering assignment.

Tip: Avoid covered calls on stocks with high beta (above 1.5) or those in speculative sectors like biotech or AI startups.

2. Ahead of Earnings or Major Catalysts

Earnings reports, FDA approvals, or merger announcements can cause massive price swings. Selling a call before such events exposes the investor to early assignment or missed upside. Even if the stock doesn’t move much, implied volatility crush after the event can make rolling or closing positions expensive.

3. In Strong Bull Markets

During broad market rallies, covered calls systematically underperform. The S&P 500’s historical average annual return is around 10%, but much of that comes from concentrated bursts of growth. By capping gains on individual holdings, investors compound opportunity cost across their portfolio.

4. With Poorly Selected Strike Prices

Choosing a strike price too close to the current market price increases the likelihood of assignment. A common mistake is selling at-the-money (ATM) calls for higher premiums without considering the probability of upside movement.

5. When Holding Long-Term Winners

If you own a stock with strong fundamentals and long-term growth potential, writing calls repeatedly may lead to premature exits. Over time, this habit can erode wealth by forcing sales just as the stock enters its most profitable phase.

Opportunity Cost: The Hidden Risk

While most discussions focus on direct losses, the biggest danger of covered calls is opportunity cost—the value of what you give up. Consider this hypothetical:

Scenario	Stock Price Start	Stock Price End	Premium Received	Total Return
No Covered Call	$100	$140	$0	40%
Sold $110 Call	$100	$140	$3	13% ($10 capital gain + $3 premium)

In this case, the covered call investor earns a modest 13% while missing out on a 40% gain. That 27-point difference isn’t a loss on paper, but it represents real lost wealth over time. Compounded over years, this drag can significantly impact portfolio performance.

Mini Case Study: The Tesla Investor Who Capped Gains

In early 2020, an investor bought 100 shares of Tesla at $860 and began selling monthly $900 calls for around $20 each. Over six months, they collected $120 per share in premiums—a solid 14% return on cost.

But in July 2020, Tesla announced a surprise battery innovation and surged to $1,800 within weeks. The investor was assigned on their calls and sold their shares at $900. Their total profit: $40 capital gain + $120 premium = $160 per share, or 18.6%.

An investor who held without selling calls made a 108% return. The covered call trader earned steady income—but gave up nearly $800 per share in potential profits. The decision felt safe at the time but proved extremely costly in hindsight.

Step-by-Step Guide: When It’s Safe to Use Covered Calls

Covered calls aren’t always bad—they can be effective in the right context. Follow this checklist to determine if now is the right time:

1. Assess the stock’s outlook: Is it mature, low-volatility, and range-bound? (e.g., utilities, consumer staples)
2. Check upcoming catalysts: No major earnings, product launches, or regulatory decisions in the next 30–60 days?
3. Evaluate your holding intent: Are you willing to sell the stock at the strike price?
4. Analyze technical levels: Is the stock near resistance with limited room to run?
5. Review implied volatility: Higher IV means richer premiums, improving risk/reward.

If four or more of these conditions are met, a covered call might make sense. Otherwise, consider holding outright or using alternative strategies like cash-secured puts to enter positions.

Frequently Asked Questions

Can covered calls lead to actual losses?

Yes. If the stock price drops sharply, the premium may not offset the decline. For example, buying a stock at $50 and collecting $2 in premiums still results in a $28 loss if the stock falls to $20. The premium delays the pain but doesn’t prevent it.

Are covered calls riskier than just holding stock?

In terms of downside, no—the maximum loss is still tied to the stock price minus the premium. However, they introduce new risks: opportunity cost, early assignment, tax complications, and behavioral temptation to chase yield on unsuitable stocks.

What’s a safer alternative to covered calls?

Cash-secured puts allow you to generate income while waiting to buy a stock at a lower price. Unlike covered calls, they don’t cap upside and can be used to enter positions at a discount.

Key Checklist: When to Avoid Covered Calls

• ✅ Stock has strong growth momentum or recent breakout
• ✅ Earnings report or major news event within 30 days
• ✅ You’re emotionally attached to the stock and don’t want to sell
• ✅ Implied volatility is very low (premiums are unattractive)
• ✅ The strike price is less than 10% above current value
• ✅ Broader market is in a confirmed uptrend

Conclusion

Covered calls are not inherently bad—but they are frequently misapplied. The allure of “free money” from premiums can blind investors to the long-term cost of giving up upside on winning stocks. Used indiscriminately, this strategy can cap returns, force premature exits, and create false confidence in volatile markets.

The best investors know when to act—and when to hold back. Before selling another call, ask: Am I doing this for income, or am I avoiding a tough decision about whether to keep holding this stock? True risk management isn’t just about collecting premiums; it’s about preserving optionality and compounding growth over time.

💬 Have you ever regretted selling a covered call on a stock that later soared? Share your experience in the comments—your story could help others avoid the same trap.