How to Trade Safe Options
Safe options, or covered calls, represent a conservative approach to investing that can provide above-average stock returns. Risk is mitigated by the capture of premium paid by the call option buyer for the right to own stock. Like any option trade, the safe option strategy must be instituted from the margin account of the investor. It is recommended that anyone employing this strategy "paper trade" or practice trading the safe option strategy for an extended period of time before entering into real trades.
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Things You'll Need
- Calculator or spreadsheet program
- Internet access
- Online brokerage account
Instructions
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What Are Safe Options?
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Trade safe options just as you would any covered call options. The investor simultaneously buys a common stock and sells a call option on the same stock. The buyer of the call option pays the seller a premium for the right to call or demand the stock anytime between now and the expiration date of the stock at an agreed-upon price. The agreed price is called the "strike price". Covered call writing is a safe option because the seller has the stock in his position if the stock is called. Naked call writing is not safe. It involves selling a call but not owning the underlying stock necessary for delivery.
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Pick a stock that you have thoroughly researched both fundamentally and technically. Choose a stock has little downside risk and moderate to high upside risk. The stock may pay a dividend that limits downside risk. Investigation of the stock indicates that the stock is in a breakout pattern, which indicates some upside to the stock.
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Choose a strike price where you would sell the stock. For example, the stock can be bought at 40. The investor believes the stock might rise to 45 in the next three months. The option buyer will pay 2 points for the right to call the option at any time with a 45 strike price. Buy the stock at 40 and sell a call equal to the number of shares purchased with a 45 strike.
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Subtract the 2 points you received from the stock purchase price. Your effective cost is 38. If the stock closes below 38 at the end of the expiration date, you will have mitigated your loss; you will still own the stock and you will have the ability to sell another call on the stock and pocket another premium. If the stock rises to 44.99, the option holder cannot exercise his option. In this case, you will own the stock, have made 2 points of cash and have an unrecognized gain of 4.99 points. In either one of these cases, you are better off having pursued the covered call option than not.
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Lose the stock if it proceeds to trade above your strike price at any time by choice of the option buyer. You will have recognized 7 points of profit. Any other rise in the stock price above 47 (the strike price plus the premium) is an opportunity loss to the safe option seller. Safe option traders usually trade in the near months of trading because the premium paid for writing the option is richest. Option premiums decline on a relative basis the longer the option period extends.
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Tips & Warnings
Depending on your risk appetite, some traders will buy back the option they sold at a profit if the stock price declines. Then their only position is being long the stock. When the stock recovers, they self the option again.
Paper trading is strongly recommended so the investor can see the result of using this strategy in bull and bear markets.
Resources
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