In general, buying stock is a relatively risky investment given that the underlying equity could go to zero in a worst-case scenario. However, it is possible to lower some of that risk on stock that is already appreciated by selling calls against it. If your technical and fundamental analysis techniques have you in equities that profit more often than not then selling option premium is a terrific way to increase returns and reduce risk. Learn more about my Stock Options Trading strategies.
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Returns can be enhanced significantly by writing a covered call on appreciated stock by using calls that only have 3 to 6 months to expiration. By employing a LEAPS covered call can generate an even higher return. In addition, writing a call against a stock that has risen in value provides the trader with the capability to lock in profits assuming the stock does not close below breakeven at option expiration. Breakeven is calculated by subtracting the premium received from the sale of the call option from the cost of the stock.
By selling option premium against appreciated stock can also help the trader conquer one of the most difficult aspect of investing which is selling a stock that is profitable. Many times this is tough for the trader to do emotionally, however it is a necessary part of effective money management, especially if the stock enters a downtrend. The greed factor can sometimes cause the trader to hold onto a profitable stock longer than they should.
Writing covered calls in this manner also provides protection for the trader's stock in the event of a price decline. This protection is not available if the trader just simply owned the stock. Writing LEAPS covered calls on appreciated stock can provide even greater downside protection just like as previously mentioned how it can also enhance over all returns.
Covered calls can also be employed with appreciated stock to allow the trader to exit a bad trade with a profit. For example, if a stock declines substantially in price after writing a call. The profit on the short call many times will allow the trader to exit the trade before it turns into a large loss. The stock can be sold and the short option can be bought back with the net result of the spread being profitable or incurring a small loss. This cushion is created by the option premium received from selling the call.
The best time to put on a covered call trade is when the underlying stock is surging in price and the call option premium is increasing in value. For instance, say you have a 12 percent open profit in a stock purchase and you want to increase your return to 25 percent by writing a covered call, a Good-Until-Canceled [GTC] limit order can be used to sell a call option above the current price that will give you a 25 percent return. Of course you need to keep in mind that there is no guarantee that the order will be filled.
This type of use of the covered call is an excellent strategy for owners of stock that has experienced a nice appreciation. It can go a long way in lowering risk and increasing returns and it represents a very simple way to do so. For the more advanced option strategist that has appreciated stock there are even better methods to employ to lower risk and increase return such as the collar strategy. As you progress as an options strategist experiment with many of the other option/stock combination strategies that can really make you a more effective investor.
Happy Trading!
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