Trading Option Spreads Instead of Buying a Put or Call
Covered call is one of the strategies that can give income to the investors in the short term while at the same time reducing some of the downside risk. For example, suppose, you purchase a stock ABC for $20, you expect this stock to reach above $30 in the next six months. You plan to sell your stock when it reaches $30 in the future. But you want some immediate income. So instead of waiting for the price appreciation in the future, you write a six month call option on your stock ABC.
Let's say keeping in view the volatility of your stock, the call option is priced $2. So you earn $2 immediately when you sell your call options contract. By selling a covered call, you are obligated to sell your stock within the next six months to the purchaser of the call option if the price goes above $30. You make $12 ($10+$2) in case the call option is exercised. However, in case the price goes above $30 and let's say, your stock price reaches $35, you will be losing some of the capital gain ($15-$12=$3) that might have accrued to you. If the stock price does not reach $30 in the next six months, you can keep the stock as well as the options premium of $2 that you had earned while selling the call option. Let's say that the stock price falls to $16. In such a case, you have reduced your loss to $2 instead of $4. You see, you have sacrificed or limited potential capital gain in return for reducing your downside risk.
There are many options trading strategies like covered calls, protective put, straddle, spreads, collars etc. Most of the portfolio managers as well as individual investors now use options as powerful and potent tools in modifying portfolio characteristics.
Writing covered calls has been a popular strategy among investors. Portfolio managers find it appealing to write calls on some or all of the stocks in their portfolio if they view Z as the strike price at which they plan to sell the stocks any way. However by selling covered calls, they forgo their right to future capital gains in case the stock price rises above the exercise price.
The advantages of selling covered call options by investors is that they earn immediate profit while also making a possible capital gain by selling the stock at the strike price in case the call is exercised in future. In case, the price of the stock does not reach the strike price, the call holder will not exercise the option and the call will expire. The investor can keep the stocks as well as the call option premiums. The disadvantage of selling covered calls in case the stock price goes above the strike price is that the investor can lose some of the capital gain. Another disadvantage is that the call seller cannot sell the underlying stock without first purchasing the call option back.
Mr. Ahmad Hassam has done Masters from Harvard University. He is interested in day trading stocks and currencies.
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