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Understanding Covered Calls

Why Understanding Covered Calls is Essential to Success

Understanding covered calls and the alternative ways you can use them, is essential if you wish to make consistent profits from this popular option trading strategy.

You need to have some idea about where the current price of the underlying financial instrument is, both within its own long term trading cycle and in the wider context of the overall market. Once you have established this, you can then tailor your covered call writing strategy to either trade conservatively or aggressively.

You can trade covered calls on both individual company stocks and also Exchange Traded Funds (ETF's) whose portfolio of assets is designed to track the price action of major indices, currencies and some commodities.

If you're favoring company shares then it's highly recommended for investors and traders to subscribe to an advisory service that includes good fundamental analysis of companies, so that you can focus on stocks whose market price is expected to at least remain stable in the short term.

Unexpected company news, or earnings reports, can create "surprises" that can produce volatile price action. A good understanding of covered calls will help mitigate the potential dangers associated with sudden price falls, but it's never pleasant holding on to stocks following a huge price drop.

If you prefer a covered call strategy that focuses on indexes such as the Dow 30, the S&P500, Russell 2000 or Nasdaq 100 then you should look at the Exchange Traded Funds (ETF's) whose portfolio of shares are linked to the price action of these indexes. Unlike the indexes themselves, ETF's pay dividends.

The above-mentioned ETF options are far more liquid and much cheaper than the indexes themselves, thus allowing greater flexibility with regard to position sizing.

You simply need to assess the overall market direction or industry that the index reflects, and adopt positions that reflect whether the market as a whole is bullish, bearish or trading sideways.

Understanding Covered Calls - The Conservative Approach

We mention this one first, since it's probably more important to know how to reduce risk and still make reasonable profits. If you're selling covered calls in a bear market, the best way to do this, is to buy the underlying and then sell deep-in-the-money call options. Most of the premium will be comprised of 'intrinsic value' but there will also be some 'time value' there as well.

This is your initial profit. If the price of the underlying continues to fall, it will have to be significant to threaten your profitability. At this point, you can then buy back your original sold calls for a profit and then sell more at a lower strike price - thus adding to your profits and protecting yourself at the same time.

Understanding Covered Calls - The Aggressive Approach

You would use this strategy when you believe the price of the underlying is either going to remain stable or rise, in the short term.

The more aggressive approach involves purchasing the underlying and then selling out-of-the-money call options. The plan is, that you will reduce your entry price by the amount of option premium you receive - and if the price continues north, you will sell the shares at expiration date and also make a gain on them.

If the share price hasn't breached the exercise price of the 'out of the money' sold call options, you can keep the shares and sell more call options for the next month out.

If the exercise price HAS been breached, you may be forced to sell your shares but you also make a gain on them (limited to the difference between the original purchase price and the exercise price of the options) plus you keep the call option premiums.

There is greater financial risk involved with the more aggressive strategy. If the price of the stock drops instead of remains where it is, you may be carrying an unrealized loss (unless you sell the shares), although this can be mitigated. In the meantime, you collect dividends.

If you choose to hang onto the shares in the hope of a price rebound, you can buy back the sold options and sell more at a lower strike price. This may not entirely offset the loss on the shares if the price fall is significant though.

If you don't have sufficient capital to purchase enough stocks to allow you to implement a covered call strategy, (you need at least 100 shares) then you may be interested in what has become known as the Poor Man's Covered Call.