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Traditionally, when you're coming to options from the world of stocks, the first strategy you learn is to sell covered calls. There are some positive things worth saying about covered calls, but many of the purported advantages are mythical. My intention is to explain why covered call selling is actually a moderately risky approach.

What are some of the myths most commonly told to new options traders? One of the biggest is the notion that there is any meaningful distinction between investing for "income" and simply trading. For example, the "income" produced by selling the call option in a covered call trade is no different from the "trading profits" that would accrue in an account had you sold the call without first buying the stock. More importantly, what happens to that cash flow -- whether you call it income, profit, cheese, or whatever -- after the short call expires? If you're like most traders, you leave those profits in the account and may use them as capital to place a new trade; in that case, there is literally no reason to call it an income trade. If you actually withdraw the net gain from the call and use it buy some groceries or a new couch, then the income argument is a little more reasonable. (But even then: what happens after a loss? If the account is replenished, or if the lost income is not offset by a reduction in spending or etc., then there's still no clear distinction between trading for profits and investing for income.) Ultimately, I think the income jargon is just a question of marketing and wordplay: some investors like to think of themselves as conservative and income-oriented when in fact they're just traders with a slightly longer timeframe.

Similarly, the downside protection supposedly offered by a covered call position is so small it is almost misleading to refer to the change as protection at all. Strictly speaking, a long stock position has slightly more downside risk than a long stock + short call position. But the difference is just the amount of premium collected, and if you're selling one call for every 100 shares owned, as a percentage of the capital at risk in the stock, the short call premium will always be a relatively trivial amount.

That's why I think systematically selling covered calls is a very risky approach: not because of the options, actually, but because of the long stock component. A long vertical call spread or collared stock position may have similar upside potential to the covered call trade, but the former trade types will not get wiped out if the underlying asset really tanks. The price of a stock may go to zero, but for a risk-defined options spread, you can always know in advance exactly how much it will be possible to gain or lose.

IBM: Covered Call Risk Profile

Source: thinkorswim

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Fig. 1 shows how much it is possible to gain or lose on a covered call trade initiated right now in which we buy 100 International Business Machines (IBM) - Get International Business Machines Corporation Report shares for $187.35 and sell the December 190 call at $3.70. If the stock is at $190 or higher at expiration, the position makes its maximum potential profit of $635. If the stock is anywhere below our net entry price of $183.65 (187.35 less the 3.70 call premium), the position will lose money, with losses mounting as the stock falls. My claim is that covered calls are risky because they still leave you with incredible downside exposure to the stock. In my next educational article here at OP, I will discuss a simple change that will dramatically alter the risk profile of this position.

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At the time of publication, Jared Woodard held no positions in the stocks or issues mentioned.