Hedge selling call option
When most investors think of using options to hedge against declines in the market, they think of buying puts.
And that is certainly a valid strategy. But we see benefits in using options in another way, a way that allows for investors who are bullish in the long run to hedge against short-term declines in the market, as well as lower the cost basis of their investments.
Covered calls are one of the more conservative options strategies, in which an investor writes sells calls against equities or ETF's that they already own.
The impact of this is twofold.
Hedging - Using Covered Calls and Put Options to Hedge a Position | InvestorPlace
Maximum potential downside is limited: Because you collect premium for selling the call and that premium is yours to keep , your maximum potential downside is lowered.
When you are long a stock or ETF, your maximum downside is simply the amount you invested. And when you sell a covered call against that position, your cost basis is lowered, thus lowering your maximum losses. Upside potential is capped: Writing the call means that if the stock reaches the strike price, it will almost certainly be called away from you.
That is why it is crucial to sell a call that is far enough away from where the security is currently trading at for it to provide enough upside. With the markets NYSEARCA: ONEQ all up substantially so far this year, many have called into question the sustainability of the rally in the short-term. Because of the rationale behind this trade, it does not really matter if the rally is sustainable in the short-term.
This trade is structured for investors who are bullish in the long-run, but wish to hedge their short-term exposure. This trade works with both general markets and specific equities.
We will be illustrating this with one contract, however it can work in any increments of shares as a reminder, options contracts require blocks of shares.
We have an unrealized profit on this investment, but are worried about where it's going. As tempting as it may be to simply sell our holdings, we are worried that the market may simply continue to rally when we sell, thus costing us upside. In addition, if this is a taxable account, we would be incurring capital gains taxes in a situation where selling is not exactly essential.
Therefore, rather than selling, we decide to write an upside call against our holdings. However, it is important to remember what the call means to us.
It is the first outcome that represents the hedging aspect of this trade. The key factors in determining which call option to use is the premium received and how much further upside in the underlying security you can catch. Every investors personal preference level determines how far out the strike price will be. Furthermore, investors can continue to sell upside calls as each one expires, thus maintaining a rolling covered call position and collecting a steady amount of income from the premiums.
If the underlying stock never reaches the strike price, then you have the premium income. And if it does reach the strike price, then you will have realized a good profit on your investment assuming you picked a strike price that matched your investment goals.
Picking the right strike price becomes even more essential when utilizing this strategy with individual stocks. If you own shares of a stock you think will rally sharply in the future, it makes no sense to write a call below that level, since your upside will be capped.
How to Hedge Call Options | Finance - Zacks
Therefore, when using covered calls with individual stocks, it is important to use them with a stock that will not surge through the strike price unexpectedly.
Therefore, stocks that you are bullish on, but expect to be relatively stable until options expiration are the ideal types of stocks for this strategy.
Such stocks allow you to collect premium income and still receive a good profit if it were to hit the strike price. While covered calls may not be the most obvious type of hedge against a short-term decline in the market, we think they can be useful to investors who are bullish in the long-term, but want to lower their potential losses in the short-term, and generate some income in the process.
As long as investors choose a strike price at which they are comfortable having their profits capped, we see covered calls as a good way to reduce losses and provide income, as well as provide for reasonable profits if the option is exercised.
I am long DIA. Hedge The Market Top By Writing Covered Calls Mar.
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