February 4, 2011
Reasons To Sell Covered Calls In A Rising Market
Most investors love a rising market. But as stocks keep going up, investors should consider covered calls. I know… why would you want to place a maximum on your upside potential just as stocks are rising? Well, there are several reasons, actually. Maybe there is an upcoming product or earnings announcement? Or maybe you are trading on margin. There are solid arguments to be made for increasing your safety net by taking a possibly smaller profit. Let’s look at some of the reasons you may want to write covered calls as the market is rising:
Take some gains. After a nice increase in stock price it is wise to either reduce your position, or write some calls against it so that if the stock gives back some of its gains you can capture some from the call premium. These two points can be combined by selling covered calls that are ITM (in the money) on the portion of the stock you were planning on selling anyway, as a way to get a bit more profit from the position. Or, if you’re still very bullish then try selling some near-term out of the money covered calls.
Income. You may have core positions that you plan to own for many years. In that case, writing some out of the money calls to generate some extra cash? You can set the max upside potential as high as you like (by choosing a high strike price). Depending on the strike price you choose, you may need to sell several months worth of time premium instead of just the near-month in order to get something meaningful from them.
Momentum. Maybe a stock has risen more than the market recently and the momentum investors are increasing their bets. In doing so they usually increase the call premiums to where they’re just too juicy to not try a deep in the money buy-write (eg. LULU, NFLX). These can be volatile so it is probably wise to keep the time horizons short (i.e. sell the near month, and not 3-6 months out).
News. Prior to a scheduled earnings or product announcements it is normal for the option premiums to increase. But rather than buying into the anticipated news item, consider selling the excitement by selling a covered call. The amount that the option is OTM or ITM (out of the money or in the money) should match your thoughts on which way the news will go.
Borrowing. Using margin to trade stocks can be dangerous. You can experience quick losses if there is a sudden move against you. One way to increase your safety net is by writing DITM (deep in the money) calls against your holdings. You may still have losses if there is a fast move down, but the intrinsic value and time premium should buy you enough time to close out the position if you need to with a smaller loss than if you had just held the stock outright.
The Born To Sell website is all about finding good covered call investments. If there was an options trading for dummies book you wouldn’t need it, because the tutorial answers your questions here http://www.borntosell.com/covered-call-tutorial/options-trading-for-dummies
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