While there are many benefits that can be created by using covered call strategies, these techniques can be particularly helpful for those who want to mitigate the downside risk that exists during bear markets.
While there are many benefits that can be created by using covered call strategies, these techniques can be particularly helpful for those who want to mitigate the downside risk that exists during bear markets.
For those who want to make money investing, such conditions can be intimidating. Investors have frequently suffered significant loss to their principal during such downward-sloping markets, and they might be very happy to know that there are some strategies they can use to reduce the associated impact.
Managing Risk With Covered Calls
Covered call strategies, which involve investors selling call options on assets they own, can be used to manage the downside risk that exists when markets move lower in value. Individuals obtain a premium when they write these contracts. This income can be used to help offset any losses that happen as asset values decline.
It is also important to note that when an individual writes a covered call, the risk that he is assuming is that his assets will be purchased or “called” away by the person or entity owning the contract. This potential outcome can be problematic if the call is sold during a bull market.
If a person uses one of these strategies when markets are appreciating, there is a higher chance that the underlying securities will be bought. In that event, the market participant who sold the call is at risk of losing out on the subsequent gains that he or she would have enjoyed.
However, the odds that one of these calls will be used are far lower in the event that the market is moving lower in value. Such a situation could be beneficial to a person who is writing a call to gather some income, but does not want to sell his assets sold to the owner of the contract.
Covered Calls & Dividends
Individuals who are considering managing their downside risk by using covered call strategies during bear markets might want to keep in mind that they can potentially obtain even higher income by writing these options contracts on stocks that pay dividends.
Investors who wish to do so must keep in mind that they need to pay strict attention to detail in order to both earn a premium and also receive the dividends that are paid for their underlying security. They can benefit from writing a contract that expires after the ex-dividend date. Individuals who are considering such strategies might also want to keep in mind that if they set the expiry date for the contract too close to the ex-dividend date, it could result in the contract owner having a higher chance of exercising a call.
Naked Call Considerations
Individuals who are considering using covered call strategies to either make money or alternatively reduce whatever losses they would experience should keep in mind one alternative to writing covered calls, which is referred to as writing naked calls. Such strategies involve individuals writing call options on securities that they themselves do not own.
The benefit of doing so is that the investor who sells these calls generates a premium without actually having to be in possession on the underlying security. However, such a move carries considerable risk. If a person sells a call option on assets that he does not own, and then the contract holder decides to use the option to buy the underling securities, the individual who wrote the call will need to purchase the financial instruments and then sell them to the buyer of the call. Such a situation could potentially set the person writing the call up for unlimited losses.
Any investor who is interested in using covered calls should know that these contracts can be harnessed to reduce risk during bull markets. However, an individual must be sure to conduct his due diligence and do the needed research so that he will be prepared to execute these covered call strategies effectively.
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