A portfolio manager uses a covered call strategy on a significant portion of his equity holdings to generate additional income. He writes out-of-the-money call options against his long stock positions. Which of the following best describes a key risk of this strategy?
- AUnlimited downside risk if the stock price falls significantly.
- BSignificant capital outlay required to initiate the strategy.
- CLimited upside potential if the stock price rises significantly.
- DIncreased exposure to unexpected interest rate changes.
Show answer & explanationAnswer & explanation
Correct answer: C. Limited upside potential if the stock price rises significantly.
A covered call strategy involves holding a long position in a stock and selling call options against it. While it generates premium income and offers some downside protection (up to the premium received), the key drawback is that if the stock price rises significantly above the strike price of the sold call, the investor's upside potential is capped at the strike price plus the premium received, because the stock will likely be called away. The investor forfeits any further gains above the strike price.
Why the other options are wrong
- A. There isn't unlimited downside risk; the downside risk is the loss on the stock position, partially offset by the premium received. It's not 'unlimited'.
- B. The strategy involves selling calls, generating income, and is 'covered' by existing stock holdings, so it does not require a significant additional capital outlay. In fact, it generates cash (premium).
- D. While interest rates can affect option pricing generally, this is not the primary or most significant risk directly associated with the mechanics of a covered call strategy in this context.
Covered Call Strategy
An options strategy involving holding a long position in a stock and simultaneously selling (writing) a call option on that same stock. It's used to generate income (from the premium) and offers limited downside protection.
- Reduces volatility and generates income.
- Limits upside profit potential if the stock price rises substantially.
- Suitable for investors who expect moderate price movements or slight declines.
Memory trick: Covered Call: Shielding your stock, but capping your climb.