Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Those not familiar with options trading often talk of how risky options are to trade. As Optionetics students, we know that options should be used to hedge risk, not add to it. Ironically, brokers who tell traders to avoid trading options often tell them that the only safe strategy is a covered call. Though there is a time and place for covered calls, they are not as safe as made out to be by many “gurus.”
|
There are two ways to use covered calls: One is a buy-write strategy and the other is selling calls on long term stocks already in a portfolio. In review, a covered call is made up of long stock, with calls sold to bring in premium. It is called a covered call because we have stock to protect the trade if the call moves in the money. Of course, the risk here is that the stock will be called away. However, by using this strategy in a retirement account, investors can bring in solid returns on a monthly basis.

The thing we normally want to avoid is doing a buy-write. This is when we simultaneously buy stock and sell calls just to make a return on the sell. A buy-write trader doesn’t have any attachment to the stock and is just trying to make a quick return on the trade. The problem with this strategy is the risk that is associated. When we buy stock, we have to use a lot of capital, even when we buy on margin. The premium we bring in for selling calls is minor compared to the risk of the stock falling sharply.

Traders can often bring in 5 to 10 percent in monthly returns using a buy-write strategy, but all these gains can be erased quickly if a stock falls sharply. There are dozens of Internet sites and newsletters that help traders find good covered call candidates. These stocks are chosen for their return using a covered call. Of course, if the return is high, it means implied volatility is also high, which is what provides the nice premium on the call. If the stock drops sharply, which happens frequently, the 50-cents to a dollar that is brought in by selling the call does little to offset the loss.

Covered calls are a very popular strategy, but make sure you understand the risks of using a buy-write. Always view a risk graph of a trade to see the true risk that is inherent. This will often convince us that a certain trade is not worth the risk.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
Visit Jody's Forum

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jody Osborne, Optionetics.com

• January 6, 2009
  Morning Watch, January 6
• January 5, 2009
  Economic Watchdog, January 5
• January 5, 2009
  Closing Wrap-Up, January 5
• January 5, 2009
  Morning Watch, January 5
• January 2, 2009
  Closing Wrap-Up, January 2