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Trading Covered Calls - Part Three |
by John Jagerson
Covered calls, when applied consistently over the long term, deliver significantly lower account volatility without decreasing profit potential. In fact, long term covered call indexes show that account volatility is reduced and returns are increased. A covered call is one of the very few ways to accomplish these two objectives at the same time and is a gateway to learning more about using options as an investor.
As we discussed in the previous articles during short-term rallies a covered call can sometimes cap profit potential on the underlying stock. This happens because you can only make the premium you were paid when you sold the option plus the strike price for the stock itself. If the stock is running away to the upside you may have made more just holding the stock.
Before we start the case-study you may want to check out:
- Part one in this series on selling covered calls options.
- Part two in this series on selling covered calls options.
However, if the market breaks to the downside, the option will expire worthless and you get to keep the entire premium because you will not have to sell the stock at expiration. That premium offsets some or all of the losses you might have accumulated on the underlying stock when it dropped. Over the long term the reduction in losses more than offsets the opportunity cost of limited gains when the market really takes off.
When you net out the affects of capped gains and hedged losses with covered calls, the end result is a strategy that can reduce the ups and downs of your portfolio but still deliver great returns. In the video, we will look at a classic illustration of this concept that can be monitored in the market every day.
There are a few final concepts to keep in mind as you become a covered call investor.
1. Be careful about commissions if you buy the stock and sell the call at the same time, this trade is called a buy-write. Call your broker and talk to them about this order type and any restrictions or additional costs they may have.
2. Covered calls require the lowest level of options trading approval from your broker. Call and make sure this is something you have permission to do in your account.
3. You can exit a covered call at anytime. If you want to get out, all you need to do is buy the call back at the current ask price and sell the stock.
4. Many traders will choose to exit a call that has moved in the money that could be exercised at expiration to avoid having to sell the stock they own in their account. There is nothing wrong with this; it is really up to you. It can avoid the hassle and transaction costs of clearing the underlying stock, especially since you’ll often write calls on the same stock over and over.
5. There are a lot of options writing and covered call “advisory services” promising huge returns. These are seldom true and may come with big fees and lots of account volatility. If you see promises or examples of huge monthly returns from covered calls, be careful; you are probably not getting the whole story.
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