Covered calls are a special type of options trading strategy in which a trader who has a long hold on a certain asset will also sell call options on the very same asset in an effort to increase the long term earnings of their investments. Confused? Don’t sweat it, we are going to go over the details of this options trading strategy.
This trading strategy is also sometimes referred to as “buy-write” because the trader will buy an asset but also write an option. So why would a trader use this particular strategy? After all, what’s the point of buying an asset but then writing options based on your own assets?
A covered call is a good strategy for traders who have a neutral short-term view of a specific stock or asset but firmly believe in its long-term potential. You get to hold onto your stock, but you also make money by writing options and receiving the premium.
Covered Call Example
Let’s say you own shares of Acme Gadgets. The company will be launching a new product in the future. However, for right now the company is selling some rather stagnant and out-of-date products. You’re not so confident that Acme Gadgets will excel in the near future. You firmly believe though that in the company’s long-term potential. For this reason, you want to hold on to your stock, even if prices will remain flat through the near term.
In the mean time, you can sell call options for the stocks you own. This way, you are paid the premium for the stocks. Assuming that the prices do indeed remain flat and the options are not exercised, you will end up making quite a bit of money. The same is true if stock prices fall. You’ll keep the premium from the options sold, though you will end up losing some money on your stocks. Either way, you can reduce your losses, meaning you will out perform markets.
Covered Call Risk
The only risk for using a covered call is if prices rise. If so, the options will almost certainly be exercised. You will have to sell your stocks at the pre-agreed upon price. Your upside will be capped at the predetermined price, plus any premium made from selling the options.
Now think on what was just said. In this scenario, you essentially make money, or at least out perform markets no matter what happens. Your biggest risk is that your gains will be capped, which is certainly undesirable if stocks should post big gains. Although in the world of trading, this is a somewhat restrained risk.
Options Strategy for Newbies
Covered calls are among the better options strategies for newer investors. Why is that? Because the risks are relatively low, especially as far as options go. Options trading is generally a higher risk investment, though the upside can be huge. With covered calls, the upside is a bit more limited, but the risks are correspondingly lower.
If you are looking to get into options trading, we recommend that you consider this strategy, especially as you are starting out. It will help you become familiar with the ins and outs of options trading. It will help you understand more advanced concepts, such as strangle and straddle strategies and many more.
If you are looking to invest in options, make sure you consider atd, or Automated Trading Desk LLC as it is otherwise known. This interactive broker offers some of the best day trading software and is perhaps the best trading platform out there. There are other great options, however, and you should do some research to figure out what works best.
Options trading is a great way for traders to expand their trading activities to outside of more traditional assets, such as stocks and bonds. While the risks of options trading are often high, the potential rewards can be very substantial. So make sure you consider options as a financial investment option!