The Covered Call That Was Not Covered
Mrs. Cho, 71, is retired and drawing 3,000 a month from a 600,000 portfolio of dividend stocks. Her options approval level permits covered calls only, and she has used them twice. She now wants to sell ten put contracts on Daehan Materials at a 45 strike, currently trading at 47, to 'get paid while I wait to buy it cheaper,' saying she is happy to be assigned and has 20,000 of cash available in the account. Separately, she owns 5,000 shares of Daehan pledged as collateral for a 60,000 margin loan, and she wants to write covered calls on all 5,000 to generate income. She also asks whether writing calls against the position would 'protect' the account, since Daehan is now 35% of her portfolio and she is uneasy about it. Her stated priority is dependable monthly income with limited loss of principal, and she has said she cannot tolerate a large drawdown.
1. Can she sell the ten puts as described? Analyze the approval level, the cash requirement, and suitability.
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No, not as presented. Selling a put creates an obligation to buy 100 shares per contract at the strike if assigned, so ten contracts at a 45 strike is a potential 45,000 purchase obligation. That is eleven and a quarter months of her current monthly draw, and it is a naked or cash-secured short put position, which her covered-call-only approval does not cover. Her 20,000 of cash is less than half of what securing the position would require; a cash-secured put needs the full strike amount set aside and unavailable for anything else.
The stated intent to be assigned does not make the position conservative. Assignment is not discretionary: it usually happens when the stock has fallen below the strike, which is precisely the scenario in which she would be buying a declining asset with money she is living on. For a client whose stated objectives are dependable income and limited principal loss, this trade is a mismatch on both axis. The correct response is to decline the order as outside her approval, explain the obligation mechanics with the 45,000 figure, and if she still wants put selling, require a new approval review with documented suitability and sufficient cash, or an alternative such as a secured cash position or a limit buy order.
2. May she write covered calls on the 5,000 shares pledged for the margin loan?
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Not without resolving the pledge first. A call is 'covered' only if the shares are actually available to deliver on assignment. Shares pledged as collateral for a margin loan are encumbered, and the lender's interest comes first; if the calls are assigned and the shares cannot be delivered, the account is left short the stock and exposed to unlimited upside risk, which converts a supposedly conservative income strategy into a naked position. Writing calls across all 5,000 shares also removes any upside participation on the entire holding.
Before any order, verify with operations how the shares are registered and whether they are free and clear, and how many can be delivered. If the lien is not released, the permitted quantity is zero or limited to unencumbered shares. Then check whether the encumbrance plus the options position breaches the firm's collateral maintenance requirements, since assignment would move shares out and could trigger a margin call. Document the share availability, the number of contracts matched to deliverable shares, and the client's acknowledgment that assignment means the shares are sold at the strike, capping her upside.
3. She asks whether covered calls would 'protect' the account against a Daehan decline. How do you answer, and what else should be considered?
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Answer honestly: covered calls generate premium, they do not protect against a decline of any consequence. The premium collected only offsets losses up to the amount received; beyond that the stock falls and so does the account, and the calls add no downside hedge. What they do is cap the upside at the strike. For someone uneasy about a 35% concentration, that is close to the opposite of what she is asking for.
The underlying issue is the concentration, not the options overlay. A single position at 35% of a 600,000 portfolio, in a client drawing monthly income and stating a low tolerance for drawdown, warrants a documented suitability conversation about reducing the position through a staged sale, using the proceeds to fund the income need, and considering tax consequences of the embedded gain before trading. If she wants protection, the instruments that actually provide it are put options, a collar, or simply selling down; each has a cost or a tax effect that must be on the table. Whatever is chosen, record that she was told covered calls are income, not insurance, and that the call premium does not solve the concentration.