I have been posting this on another forum. Thought I'd copy it to here as well:
Covered calls are promoted as a cashflow panacea/certain income by certain wealth seminar promoters. I have always begged to differ.
Once again though, I am at pains to point out that they do have their place, under certain circumstances.
It seems the feature that is attractive to people is the positive theta. In other words, people want a stream of income.
The problem with covered calls depends on the situation.
1/ If a call is sold on an existing share holding, there is always the risk of your shares being called away. If you have significate capital gains realized by this transaction, a taxable event would have been precipitated and the tax man will have his hand straight in your pocket and will take more than the call premium you recieved.
No problem you say. I can roll up and/or out or close out the position. This is true, but this always beggs the question: "Why not a pure option play instead?" This way your longterm shareholding is not involved in the risk profile.
The downside of the pure option play (sold put) is that you will need extra cash to cover the put. In the event of a gap down, you will end up with more stock, possibly that you do not want.
2/ If the call is sold and the shares bought at the same time (buy write), you are intitiating a stand alone strategy. Many beginners do not understand the risk profile of such a strategy....limited upside and undefined, but very much larger possible downside.
Once again the same question: ""Why not a pure option play instead?" The risk profile is identical.
Again, theoretically, defence is possible, but with stocks there is always the risk of gaps. Particularly when there is attractive IV (and therefore premium)
There has been sooooooooooo many traders blown out of the water this way.
Credit spreads are not a hell of a lot better, particularly with near expiry/low IV options....risk/reward is crap.
When writing options we are looking for premium income, but we want to minimise risk.
Individual stocks carry substantial risk, only rank novices don't realize this. (sorry if this sounds harsh but its true)
Answer: Index options!
With index options the individual stock risk from adverse news etc is virtually negated, and you are only exposed to overall market risk. This market risk is easily defended against with the underlying future or ETF or bought options.
The person who wants to retire and write options for a living would do well by looking at these.
Not forgetting, these can be legged into fairly safely, sans individual stock risk and possibility of large gaps.