A Look On How To Use Covered Calls As A Trading Strategy
Covered calls are a method or technique used in trading of shares and other securities. Some literature calls this strategy simply as “buy write”. From a lay man perspective a covered call is simply holding of a long position while waiting for a chance to write call. This you do in order to increase returns in the given security or asset.
If you use this tool well, covered call trading strategy has the ability to generate some good profits in the long run of any security. This tool is generally considered safe if not conservative though, it has a number of flaws which we are going to have a look at. We are also going to see all the ups and downs that surround this tool.
Before we continue, a few definitions are going to help us in discussing this tool: Long call option – Here an investor buys a right or privilege to buy a given security at a predetermined date within a specific price. To get this right, he has to part with some money today, called premium.
Short call option, here you are the one who receives the payment for offering an individual a long call option. Short the put option, here you sell to someone a contract giving them the privilege to sell an underlying before a future date. They are not obliged to sell to you. These four definitions are the core of any buy write strategy.
We are now going to have a look on how to set this strategy up. To set this tool you will need to do two very basic things. First you will have to identify a security that has good prospects in the long term. The next thing to do is to buy say five blocks shares. This is entirely dependent on how much you are willing to invest. Basically a block of shares is one hundred shares.
The next thing to do after you have done these two basic steps is to sell call options on the blocks you which have just bought. This will bring you some money which you will deposit into your account. This step sounds very basic but it is usually the most sensitive part since you have to determine when to sell.
Below a detailed example shows just how this tool works, it is an example of a trader who had some shares which he used to buy some covered calls. An investor has 500 shares which are valued at $10000, on selling five call options you make $1500. This is done on the assumption that one covered call is around 100 shares.
This means that the investor can only lose money when the stock drops by more than $1500. This will be a safety measure on the seller in case the prices of the stock drop since the seller has the premium that is the $1500 and can only lose money if the stock deeps below $8500. The disadvantage of is that once the period expires he should not sell calls at a price lower than the price he paid for the stock. Basically this is how covered calls work.
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