Question By Apurva Tewari
"Is Covered Call The Safest?"
IS writing covered call is the safest option trading strategy?
Consider the core elements in an options trade
Asked on 22 April 2009
Answered by Mr. OppiE
Hi Apurva Tewari,
First of all, there is no such thing as a "SAFEST" options trading strategy.
All options trading strategies have the potential to lose money if their underlying stocks do not perform within the expectations of the options strategies. As an options trader, you need to measure the maximum loss potential of the options strategy you are using and then size your position according to your loss tolerance.
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For options strategies with unlimited loss potential (such as covered call), you need to make sure you use only money you can afford to lose totally or set a stop loss at your maximum loss limit.
In this sense, a Covered Call carries the same maximum risk as any other options trading strategies as long as you place your stop loss properly.
For example, a Covered Call with a stop loss point to keep maximum loss to $500 has exactly the same maximum loss potential as using $500 on straight forward call options, right?
Now, lets explore Covered Calls deeper.
What makes Covered Calls seem so "safe" to most options trading beginners? First of all, it take a lot of money to do Covered calls because you need to buy the underlying stock (unless you are buying very very cheap stocks which makes it all the more dangerous) which takes up a lot of money.
This is excellent protection for beginners who have a poor sense of position sizing.
A Covered Call is indeed safer than just buying call options if you are using the same amount of money. This is assuming you did not buy shares of one of those companies that suddenly declare bankrupt. Putting all your money in one company does increase the risk manifold, even if you use a Covered Call.
Covered calls profits in more than one direction.
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You make money when the stock goes up, stays stagnant or drops very very slightly. Being able to profit in more than one direction makes the covered call a safer options strategy than a single direction strategy such as buying call options directly.
In this case, the Covered Call has a higher probability of success due to its ability to profit in more than one direction. However, there are also other options strategies that profits in all 3 ways such as the Call Ratio Spread.
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So this "safety" isn't the proprietary rights of Covered Calls.
Lastly, I think Covered Calls are popular amongst beginners because most beginners have already traded shares before and own some shares in their accounts. This makes executing the Covered Call extremely convenient and easy to understand.
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In conclusion, there is no such thing as a "safest" options trading strategy. The Covered Call, being a limited profit and unlimited risk bullish options strategy does have its drawbacks and you can lose a lot of money if things go wrong and you do not have a stop loss in place.
As an options trader, it is imperative to understand position sizing in relation to the options strategy that you are using so that you are always in control of your maximum risk.
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There is one way to do Covered Calls that is almost risk-free though; It is known as the Deep In The Money Covered Call.
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