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The Popularity of Covered Call Strategy

May 28, 2012 | Comments: 0 | Views: 111

Covered call strategy has become a well-used approach in stock investments and is widely used by buyers and sellers alike. This has been so because using covered calls strategy will limit the amount of money you lose if the stock price goes down. If it doesn't go down with much, you will even win money. How is this possible? Let's take a situation where let's say you have some stock shares that are worth $60 each. You write a call option at a premium of $5 and a strike price of $65. So from the beginning you win $5 no matter what happens. If the stock price goes to $56, then you still are making $1 profit. Without writing the call option, you would have lost $4 per share. Of course, if the stock price goes up, the maximum amount of money you can win is limited, but in any case it is a great strategy to use if you want to play it safe.

In the investment business, the use of covered calls and the writing of covered call options has become a financial strategy preferred more and more by investors from all over the world. For example, the "Charles Schwab & Co" admitted the fact that 4 out of 5 of their investors prefer to use this strategy. This further solidifies its popularity in the market. Another way of looking at it is that it is a contract between a seller and a buyer that gives the buyer the right, but not the obligation, of acquiring a certain number of stocks from the seller for a certain fee during a certain period of time which are all defined in the contract. An option is a security that offers the seller a downside-protection to his stocks if they go down, and that is why writing a covered call has become such a popular financial strategy.

If covered call provides a great downside protection, opting to not use this approach could potentially lead to earning maximum upside potential on your stocks. It really is quite hard to have the best of both worlds. But how do you define upside potential? The upside potential is the call price minus the stock price where ideally the strike price should be bigger than the stock price (referred to as OTM "out of money"). For example, if the call strike is 50 and the stock price is 40, then the potential upside will be 10. If the call strike is 40 and the stock price is 50, the stock has 0 potential. Even if an investor normally will want the safety of their "In the Money" (ITM ) option, there might be situations where they will prefer the OTM option. For example he might want to reduce the chances of the stock being called away, or he might believe that the stock will go up until the option expiration date. In any case, if an investor wants to have a maximum upside potential, then he would think twice in using a covered call strategy because writing a call option will limit the maximum upside potential.

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Source: EzineArticles
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