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Covered calls, when applied consistently over the long term, deliver significantly lower account volatility without decreasing profit potential.
In fact, long-term covered call indexes show that account volatility is reduced and returns are increased. A covered call is one of the very few ways to accomplish these two objectives at the same time, and is a gateway to learning more about using options as an investor.
As we discussed in the previous articles (see part 1 on writing options and part 2 on selling covered calls options), during short-term rallies a covered call can sometimes cap profit potential on the underlying stock.
This happens because you can only make the premium you were paid when you sold the option plus the strike price for the stock itself. If the stock is running away to the upside, you may have made more just holding the stock.
However, if the market breaks to the downside, the option will expire worthless and you get to keep the entire premium because you will not have to sell the stock at expiration.
That premium offsets some or all of the losses you might have accumulated on the underlying stock when it dropped. Over the long term, the reduction in losses more than offsets the opportunity cost of limited gains when the market really takes off.
When you net out the effects of capped gains and hedged losses with covered calls, the end result is a strategy that can reduce the ups and downs of your portfolio but still deliver great returns.
In the video below, we will look at a classic illustration of this concept that can be monitored in the market every day.
For more on covered calls, see: