Covered Call Pitfalls for Dividend Investors
Think twice before engaging in this dividend stock approach.
A covered call options strategy can squeeze extra income out of your stock portfolio. Be careful, however. The benefits of covered calls are tempting and apparent, while the drawbacks are hidden and insidious.
If you don’t know what you’re getting into, your experience won’t be what you hoped for. Dividend investors are particularly susceptible to the temptations of covered calls. Let’s talk about the strategy with a particular emphasis on the pitfalls.
Options strategies don’t get much simpler than the covered call. You own the stock. You sell calls against your holding. The call gives the buyer the right to take your stock away at a price you theoretically would be happy to part with it for. You get to choose the stock and the call option terms. The benefit is that you collect a payment, called the premium, from the call buyer. If the underlying shares go down or do not rise too high, then you wind up better off for having sold the call option.
It almost feels like manufacturing your own stock dividend.
Dividend investors are frequently attracted to this strategy. They are income-oriented by nature. They also realize that dividend portfolios tend not to offer the spectacular upside that more growth-oriented portfolios enjoy. A stock’s regular dividend holds back its capital appreciation. It almost feels like cheating to sell upside volatility where the regular dividend imposes natural gravity on the share price.
How high is that stock really going to go?
Dividend investors can get accustomed to long periods of flattish portfolio results. It is tempting to try to tilt the odds toward better returns. Covered call sellers will often model out their future income, assuming a perpetually flat stock price. Under the assumption of flatness, they get the dividend plus the call premium and wind up with an attractive overall return.
Unfortunately, the market periodically goes through downswings. Even when the overall market is flat or rising, individual names can still experience tremendous volatility. A covered call seller, like any investor, will have portfolio landmines going off regularly, punctuated by the occasional carpet bombing. For diversified long-only investors, there is an expectation that the big winners will balance out the big losers. For the covered call seller, stocks that experience positive catalysts get called away.
Stocks that experience a steady flow of bad news linger. To excel with this strategy, you must become a real expert in identifying low-downside stocks.
This is much tougher than it sounds. Theoretically, every stock has 100% downside at all times, no matter how far it has already fallen from a previous high.
The pitch for covered calls can be convincing. The sales line I’ve heard is that options are like insurance for a stock portfolio. In any insurance market, the sellers make the money over time. Don’t you want to take advantage by going into the business of selling insurance?
From time to time the stock might randomly rip higher and you will pay out a claim (the call option), but most of the time you smugly sock away premiums for calls that expire worthless in the buyer’s hands. Then you sell a new call against the same holding, collecting steady dividends the whole time.
Here’s the lie though. You should not assume that the call buyer is some kind of nervous Nellie who is greedy for stock market upside but too cheap or too frightened to own stock outright. The buyer is probably a computer algorithm, and that algorithm has been created by mathematics Ph.D.s and is being run by a big trading firm with a very keen profit motive. You don’t fleece Wall Street. Wall Street fleeces you.
We should soften that a tad and say that there are indeed times when the public appetite for calls, either generally speaking or specifically in certain stocks, becomes so voracious that call sellers really can get the upper hand on the market in general. In that case, the trading company buying your call is generally acting more like your partner than your counterpart due to hedging mechanics that are, frankly, beyond most investors’ level of expertise.
We don’t want to say it is never smart to sell a covered call. Please understand that covered calls are not simply a carnival game where savvy, smart investors sell hopes and dreams to nervous, dumb investors. As options strategies go, covered calls are pretty simple, but the market is not a simple place. Our advice is that if you are going to play the covered call game, you should do so with a full understanding of the potential drawbacks.
You never know which side of the carnival stall you are standing on. It had better be fun for you.
Here are some of our recent stock selections can benefit your portfolio without resulting to covered calls:
This article originally appeared in the August 2025 issue of BetterInvesting magazine and is reprinted by arrangement.
