Question:
I am unfamiliar with covered calls, but it would seem like the strategy would be great only if the underlying stock price always went up? How do you generate such great returns when the stock price goes down? Do you protect against loss by using some of the call premium to buy a put each time.
Solution:
The Covered Call strategy is a ‘slightly bullish” strategy, but that doesn’t mean to say that you cannot make money when the stock is falling. The premium you receive when you write a call offers downside protection, the catch is that you “lose’ upside gain. If you write a call with downside protection of 5% and upside return of 5% that is exactly what you get. If this is written on a $20 stock it has to fall $1.00 before you “lose” and if it goes to $22.00 you still only make $1.00 (5%). The beauty is that if it does decline you get to keep all the premium and you just write another call for the next month and so on until your underlying stock value is zero. That is, if you have a $20.00 stock and you write $2 calls over 10 months your underlying stock value will be zero, so any calls you write after this will be pure profit. The management techniques in the e'book "Trading Covered Calls and LEAPS: The Safer Options" explains this in much more detail. But basically: Stock goes up = call is executed for pre-determined % return Stock does not move up or down = time element of call allows you to buy back the call for profit Stock goes down = the call expires worthless so you keep all the premium and write another call for more profit
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