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Wednesday, September 28, 2022

What Are Covered Calls And How To Use Them in Trading?

What are covered calls?

The options market can offer a low-cost, flexible and efficient means to accumulate stock. It is used to limit downside risk without selling the store or buying protective puts. There are several ways candidates for this kind of trading: One of them is using covered call strategies.

Covered Calls (or Protective Puts) – An option strategy involving the writing (selling) of an out-of-the-money (OTM) Call on an underlying stock while at the same time owning 100 shares of that underlying stock; sometimes known as “Protective Put” strategies because they limit downside risk without limiting upside potential.

The person executing this strategy has no interest in buying the underlying security unless it approaches the strike price.

The covered call strategy is an alternative to simply holding 100 shares of stock and selling calls against it.

A technique is known as a protective put. The idea behind this approach is that you can collect extra income from the option premium while still maintaining your upside potential in the underlying stock because you already own it.

Of course, if the stock moves below a certain level, you’ll be forced to sell your shares at that lower level. Still, this sale might be preferable to be exposed to significant downside risk without any means of getting out cheaply.

How to use them in trading?

Covered call writing provides three key benefits: limited downside risk, portfolio diversification, and monthly cash flow. As long as the original stock position is held, the covered call writer is protected from downside risk.

Covered calls can be used to create a form of portfolio insurance in which potential losses are reduced with only a small sacrifice of potential profits. Also, selling OTM call options provides monthly cash flow that can help meet living expenses or fund other investment accounts.

Covered Call Strategies Explained

Covered Calls are simultaneous buying and selling options contracts. In practice, covered calls are mainly used by investors who also hold or buy stocks. In this way, the investor is protected if he misses his stock buy.

In Singapore, a covered call strategy can also be used for short-selling stocks, but only on the non-marginable securities listed on SGX or those available on overseas exchanges with no restrictions by MAS.

Options traders will often use a “covered” or “protective” call when they already own 100 shares of the underlying stock and wish to limit their risk without abandoning any potential long-term benefit from further rises in the share price.

Covered calls require you to own 100 shares of underlying security before opening your position.

Covered Call Strategy Example:

You own 500 shares of ABC Corp at $10 per share. You write (Sell) 5 Call Contracts at $0.50 per share for a total credit of $250.

The trade breaks even if ABC Corp drops to $9.75, but ideally, the stock would close just below the break-even level at expiration, which happens about one out of every three times with this strategy.

Advantages

  1. A trading account with a broker is generally required to write covered calls.
  2. Stock trading sites provide real-time quotes and charting capabilities; however, options brokers do not provide charts or market news, which can be found for free elsewhere (example: at Saxo).
  3. Trading stocks vs options involves exposure to different risk and rewards profiles
  4. Covered call option strategies are dependent on time decay (theta) working in an investor’s favor [most of the time]. The price only moves when there is new information about the company, which is very infrequent.
  5. An investor may write up to 10 contracts per trade. There are many different strike prices available for investors with varying risk/reward profiles.
  6. Covered calls can be written on stocks held within an existing portfolio, allowing investors to increase their overall return potential while taking less risk than they would without this strategy in place.
  7. The covered call strategy has been found to outperform the market by an annualized average of 8% during bull markets and even more during bear markets.
  8. If you sell your call option and the stock price does not increase by much, you can also choose to let your position expire. This means that technically if the market is flat or down for the year, you will not lose any money.

Conclusion

Covered calls are an excellent way for bullish investors on their stock portfolios to generate income through limited downside exposure.

The strategy also provides necessary portfolio diversification and monthly cash flow.

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