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One of the exciting aspects of learning to trade options comes when you read about a strategy that seems too good to be true. In fact, it seems so attractive that the newcomer often jumps right into action by making a trade. Only then does the trader discover that he/she doesn’t know what to do after making the trade.
Covered call writing fits that description. This strategy is not “too good to be true.” It has its positive characteristics, but when you don’t understand options very well, it can be overly seductive.
When writing covered calls, earnings potential is high. The trade is more conservative than owning stock, and produces better profits most of the time. For the newbie who is anxious to get started, that’s enough information. Risk is not considered. How to efficiently enter and exit the trade are ignored. Further education is put on hold because this single strategy appears to be so easy and so profitable. The feeling is that the trader must get started today, or else opportunity is being squandered.
Please do not fall into that trap. There is seldom any investment that is so good and so timely that it cannot wait until you are better educated. Don’t you want to understand what you are doing and get the most mileage out of your trades? Education is the stepping stone.
Experience is beneficial, and the best way to acquire that experience is through paper trading. If you must use real money, trade small until you have proof that you can handle trade decisions well and the specific strategy chosen is working for you.
In this series of posts, I’ll introduce you to a strategy that I consider to be a sound learning experience for investors who are new to options. It’s not the “best” option strategy available, because there is no “best strategy.” So much depends on your specific investment objectives, tolerance for risk, age and bankroll.
One point I want to stress is that it’s mandatory (in my opinion) to learn first and trade later. If you are brand new to options and find this strategy to be enticing, please wait until you know more about it before getting started with real money.
What is an Option?
An option is an investment tool with a limited lifetime. The most important characteristic of an option is that it allows specific risks to be measured. To the extent that any of those risks is outside your comfort zone, you can use other options to reduce or eliminate that specific risk.
Options can be used to gamble and to seek high returns (with a small chance of success). I suggest using options to reduce risk.
What is an Option Strategy?
To use options, you must make a trade. You buy and/or sell specific options. It can be calls, puts or both.
A strategy dictates which options to buy and/or sell. The strategy is your ticket onto the playing field. If you don’t have a position, then you are sitting on the sidelines. To play, you must make a trade.
You can trade options based on your expectations for the market (or a specific stock). When those expectations come true, you can earn a profit. You can take a bullish stance and make money when markets rise. There are many ways to do that. In other words, there are enough different bullish strategies that simply “being bullish” is not enough. You will eventually learn which specific strategies you like to trade and which are not for you.
You can just as easily take a bearish stance and make money when markets fall. Other option strategies do best when the markets trade in a range and don’t move too far.
For this series, we will look at a basic strategy that is very popular among option traders: writing covered calls.
See Part II: What is Covered Call Writing?
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