Outside the Box: Understanding the Risks of Covered Call Writing
Email This Article
Print This Article
Digg This
Delicious
SubscribeMOST POPULAR ARTICLES
- Kaeppel's Corner: 2009, The Year of Investing Differently
- Option Watch: Jan 6—Mover & Shaker USG Corp.
- Kaeppel's Corner: The Early January Alert
- Weekly Outlook: January 5, 2009
- Hot Shots: "Obamaistic, Not Foolish"
- Closing Wrap-Up, January 5
- Closing Wrap-Up, January 7
- Outside the Box: Controlling Risk Is Key for a Trading Business
- Growth Stock Swing Option: Jan 5, 2009
- Midday Action: January 6
- Kaeppel's Corner: 2009, The Year of Investing Differently
- Outside the Box: Using Government Backed TIPS to Insulate a Portfolio
- Commodities Roundup: Soybeans
- Kaeppel's Corner: The Early January Alert
- Hot Shots: Wind at Our Monbacky?
- Option Watch: Jan 6—Mover & Shaker USG Corp.
- Foreign Exchange: Rise of the Euro
- Options Corner: A Butterfly for Christmas
- Hot Shots: "Obamaistic, Not Foolish"
- Interview Central: Brian Shannon, Part III
- Analytical Toolbox: Tools for Developing Your Outlook, Part I
- Market Insight: Cogent Exhibiting Strong Earnings Growth
- Midday Action: January 8
- Hot Shots: Wind at Our Monbacky?
- Outside the Box: Controlling Risk Is Key for a Trading Business
- Kaeppel's Corner: The Early January Alert
- Economic Watchdog, Jan 7
- Midday Action: January 7
- Option Watch: Jan 6—Mover & Shaker USG Corp.
- Commodities Roundup: Soybeans
SPONSORED LINKS
February 20, 2008
Many new option traders like to trade covered calls but they do so without really understanding their risk exposure. In this article we will discuss just what those risks are and lay out some of the key drawbacks in writing covered calls.
First, it is important to understand that before traders can write a covered call, they must own the stock. Option contracts are written in 100-share increments, so traders need to buy at least 100 shares of the stock they want to write a call on. Given this, it is easy to see how it can require a lot of capital outlay on many blue chip stocks trading at $60 per share or more.
In addition to the large capital outlay, another big drawback that must be pointed out is that the price of the underlying stock could decline severely. In this situation, traders cannot sell the stock; they are locked in until expiration date because by writing a covered call traders have the obligation to sell their stock at a set price until the expiration date. In this particular case traders buy back the call, which ends their obligation and frees up the stock to be sold.
Another possibility that must be considered if writing covered calls is that a stock might really start to takeoff unexpectedly. In this case, traders experience an opportunity loss in that after the stock has exceeded the strike price used plus the premium received, and they no longer gets to participate in the upward movement of the stock—which is why it is referred to as an opportunity loss.
Even though covered call writing is more attractive when volatility is high, it is much better for the options strategist to use combination strategies like bull call spreads, bull put spreads and other even more advanced type strategies. By using option combinations instead of covered calls traders have a far less capital outlay as well as improving their particular risk-to-reward profile significantly. Please keep these facts in mind about the covered call when considering its implementation.
Happy Trading.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
Visit Jeff’s Forum
Listen to Jeff at www.ProfitStrategiesRadio.com
© Copyright 1995-2009 Optionetics. All rights reserved. This material is for personal use only. Republication and re-dissemination, including posting to newsgroups, is expressly prohibited without the prior written consent of Optionetics. Optionetics is a registered trademark of Optionetics, Inc.