Writing Covered Calls – Strategies and Traps

Covered Calls Traders and investors make a common mistake when writing covered calls. Make sure you don’t fall into this trap!

Covered Call Trading – Process Definition

Covered call trading is simply selling one call option against 100 shares. An investor or trader receives a cash prize for selling a call option. This call option will eventually either end up useless or it will be exercised and the investor’s shares will be sold at a predetermined price.

If the call option is exercised and the shares are sold, the maximum return will be realized on the covered call transaction. The investor will retain the premium from the sale of the call option and will receive cash from the sale of the shares.

If the call option expires, the investor will deduct both the cash premium from the sale of the call option and the stock. You can then sell another call option and repeat the call recording process.

Covered call position risks

The most commonly assessed risk of a covered call position is a reduction in the value of the shares. A small drop is not a concern as the investor or trader can continue to sell covered calls against stocks and are protected from a modest price drop by the premium collected with each subsequent sale. However, a significant deterioration in stock value is a threat that needs to be planned.

Another commonly valued risk is writing a covered call – it’s missed costs. By selling a call option against his shares, the trader puts a limit on the potential return on the shares that are rising. Each covered call position carries the maximum return, while uncovered stocks can rise endlessly.

Many covered call traders respond to rising stock prices by buying call options. This usually results in a loss if the call option is redeemed for a larger amount than was received from the sale. It is hoped that the losses incurred by the call option will be offset, and indeed exceeded, by continued stock growth. Of course, the danger of such an approach is that stocks will not continue to rise.

More importantly, an investor or trader trying to redeem a valued call option has fallen victim to a discretionary call recording trap.

Trap call writing strategies

A distinction needs to be made between a systematic call recording strategy. Systematic covered call writing involves the systematic sale of call options against stocks for the sole purpose of collecting a monthly premium. The only concern with the underlying stock price is the possible early exit from the position that caused the stop loss. The goal is to benefit from collecting premiums over time, not from unlimited capital growth.

Discretionary traders will write calls if they think their stocks are unlikely to move higher. Their hope is to get a premium from the sale of call options during the market consolidation period, but will allow stocks to rise during market rallies. However, no one can predict future market actions.

What invariably happens is that once the calls are sold, the shares break out of the consolidation model, forcing them to redeem. Once the calls are redeemed, the market may or may not reach new highs. Eventually, there will be a pause, and the author of the discretionary call will again have fun writing another version of the call. Because it is extremely difficult to pinpoint market time, most discretionary call traders find themselves at the losing end of the equation.

Write or not write, call options

The pitfall of trying to get the “best of both worlds” is that we miss the best that each world has to offer. If you are going to write calls against your stocks, do so consistently or systematically with an emphasis on collecting a monthly premium. The premium from the monthly option sale is the place where you will find your profit.

An investor in growth must focus on maximizing the cost of capital and learn to be patient while consolidating the market. While boosting profitability with a random premium collection is an attractive idea, you’re probably best off sticking to your core strategies. If you want to take advantage of consolidation, there are alternative approaches to collecting premiums that may be more in line with your overall goals.

Of course, there are those who can successfully combine strategies. Even these few talented ones will develop their techniques with a clear purpose. Wherever you fall into a wide range of investors and traders, remember your goals and objectives and beware of the constant trap that exists for those who replace short-term profits with their long-term strategy.