When the stock falls

A covered call is easy to like in a quiet market: calls expire and the premium adds up. This lesson looks at the case that decides whether it works for you: the shares fall sharply.

A sharp fall, with and without the premium

Here are 100 shares with a covered call, with the forecast range set to a fall of 25% to 35% by expiration:

Trade analysis of 100 shares with a covered call, with the forecast range shaded over a fall of 25 to 35 percent: the Lowest and Highest outcomes in that range are both large losses.

And the same 100 shares on their own, over the same range:

Trade analysis of 100 shares alone over the same forecast range: Lowest and Highest are losses only slightly larger than the covered call's.

Compare Lowest and Highest in the two. The difference between them is the premium, and against a fall this size it’s small. In a sharp fall, a covered call loses nearly as much as simply owning the stock. In a sharp rise, it gains much less. That’s the trade: steadier results in calm markets, in exchange for giving up the big rallies and keeping nearly all of the big falls.

Now read Probability, the model’s chance of a fall this large. It’s tiny, often small enough to show as 0%, and it’s too low. The model assumes a lognormal distribution with one volatility, and real markets fall this far more often than that assumes. Disclosures & Model Limits says so directly. Rare isn’t the same as won’t happen, and over years of selling calls, it’s likely to happen at least once.

Open the live version: both positions on today’s delayed prices. Drag the forecast range to other outcomes and compare them.

After the fall

After a fall like this, the hard question is what call to sell next. Three ways to run it compares the choices on today’s prices.

Questions to answer before you start

None of these has a right answer, and none of them is advice. Each is easier to answer before the fall than during it.

Would I be comfortable holding these shares through a fall of a third? If not, a covered call doesn’t change that; it’s still the shares’ downside.
What will I do with the calls after a fall? Sell at my cost, sell nearer the price, or close the position.
How much of my account is in it? Every covered call rides on 100 shares, and every cash-secured put commits the strike times 100. Several at once, on stocks that fall together, is one large position.

With a brokerage connected, the stress tester can put a sharp fall to your whole account at once, across every position you hold.

What’s next

Cash-secured puts: the same position from the other side: why a short put carries the same downside.
Disclosures & Model Limits: what the probabilities assume. They’re models, not forecasts, and not investment advice.