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Tips for trading covered calls

TradingPub Admin | June 17, 2013

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If you are interested in making use of covered call strategies, you might benefit from free trading education that contains tips on how to engage in such methods effectively.

Basics of covered calls
Engaging in covered calls entails either buying or owning assets and then writing call options on those securities. For example, you could buy 100 shares of a company's stock and then write a call option on those units of ownership.

This technique is frequently used to bolster income, since if you write a call option on shares you own, you receive the premium. Writing covered calls can also be used to help manage risk. The idea is that if you buy a stock when you think that the market is going down, then your exposure to the downward price movements of the assets you own will be reduced by the premiums generated through writing these calls.

The alternative to writing a covered call would be writing a naked call, which would involve selling a call option on assets that you do not currently own. Doing so would be a riskier approach, because if the buyer used the call option and decided to purchase the assets, you would need to purchase the securities at the predetermined price.

Timing is key
While you may be drawn to covered call writing strategies due to the potential income that can be generated, there are certain caveats you should observe in order to maximize the benefits that can be derived from this activity.

One popular strategy that people use involves buying shares of stock that make dividend payments and then writing call options on these securities. If you opt for this technique, you can benefit from not only the premiums generated by selling the call options, but also the dividend payments involved.

However, the timing you use when engaging in such a strategy is very important. In a recent opinion piece on Stock Trading To Go, covered call expert and financial writer Mike Scanlin notes that you can miss out on the dividend payment if you do not have the correct timeline established for the call option.

He emphasized that you should aim to have option expiration happen after the ex-dividend dates on your underlying securities. Scanlin noted that your calls be may exercised early if there is a small amount of time value left on the contracts right before the ex-dividend date.

Be ready to retain the underlying asset
It is important to note that while market conditions may motivate the person owning the call option to buy the underlying assets, there is no guarantee that this will be the case. For example, if you write one of these contracts on some shares of stock and then the securities fall significantly in value, the buyer of the contract may simply opt to let it expire instead of purchasing the financial instruments at the predetermined price.

Keep in mind that there are many different potential market scenarios that could happen after you write the call option on your underlying securities. For example, markets could move upward, and if the stocks contained in the call move with it, then the contract holder will probably opt to exercise his option contract and buy the assets. You might also encounter choppy markets, in which case the person that you sold the call might act differently.

Scanlin advises that in all different cases, you should be ready to retain ownership of the underlying stock that you have. Even if you think that the contract owner is going to buy up the assets, he may not do so.

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