Covered calls are common in Hong Kong trading. These options allow investors to earn additional income via short-term positions, an effective strategy for above-average returns. However, covered calls are not suitable for all traders, and they do bring added risk, so it is essential to understand them fully before trading them.
Why use covered calls?
Covered calls can be used as a defensive or conservative strategy that involves selling call options against existing long position holdings rather than buying new ones. This reduces a trader’s leverage while still allowing for a profit.
When selling calls on a stock you already own, you are covered if the security price rises above your selling price. You can theoretically buy back the shares and use them to deliver against the call option. This reduces risk if your judgment is wrong, but it also reduces potential gains.
How to trade covered calls
Experienced traders may have different thoughts about when it works best to initiate uncovered calls, but this strategy can be very effective if employed correctly. In essence, all you are doing is selling an option that gives someone else the right to buy your shares from you under certain predetermined conditions and for a guaranteed fee.
Theoretically speaking, here’s how it works. If somebody wants to buy the stock from you for $15 per share and pay you a premium of $1/share for this privilege, then cover calls work because now you have a guaranteed income of $100 from selling the call. It offsets your initial investment of $1000, and your potential risk is temporarily reduced. This reduces the effective cost of purchasing stock in this example to $9 per share and makes it more affordable for investors with small budgets.
Risks associated with covered calls
As with any trading strategy, some kind of loss can be expected even when using covered calls. The question is whether or not the result is positive or negative on a net basis after considering fees paid and dividends earned throughout owning stock long enough to sell options against them.
If everything worked out fine to generate new income through selling these contracts against your purchase of shares, all you have to do is keep writing them as long as possible. But there are many factors to consider along the way that can cause the entire strategy to backfire, so proceed with caution.
Types of covered calls
There are two types of covered calls that can compound further losses or gains.
Put options
For example, a cash-secured put sale is executed when an investor owns 100 shares of stock he intends to sell against right away but uses them as collateral for buying a put option instead. This way, he can sell his shares at $11/stake and then repurchase them for $10/share if the price falls. If it rises, he just lets the put option expire and keeps the extra cash, which is a guaranteed gain under this scenario.
Call options
There’s also something called a “buy to open” order, where you agree to purchase 100 shares of stock from somebody else for $10 apiece until June 16th, even though today’s market rate may be only $9.50 per share. In this case, the buyer of your stock would benefit from a reduced risk exposure and increased odds of profiting from a rise in share, but only if they could sell it for more than you paid at a later date. But as with all covered call strategies, there’s always something that can go wrong if not planned out properly beforehand.
In conclusion
Using covered calls is another way of increasing returns by taking on added risk. The best thing to do is experiment cautiously until you get the hang of what works and doesn’t work within your trading style. Learn more about covered calls and try a demo account at Saxo capital markets.
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