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07/12/2011

Writing Covered Calls


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Writing Covered CallsThese days, it is hard to find investments with the potential to generate attractive returns without taking on too much risk. At the conservative end of the spectrum, bond yields are well below historical norms. The average bond now yields just 2.5%/year, below the typical rate of inflation. If interest rates should recover to more normal levels, today’s bond investors would have locked in at paltry yields and may also suffer big losses in the value of their investments (particularly if they have invested in bond mutual funds as opposed to individual bonds). But, on the other hand, the stock market appears very risky after losing more than 50% from the top in 2007 to the bottom in March 2009 and after falling 16% from April-July in 2010 in response to the European debtcrisis.

There is no foolproof recipe for investment success in this climate, but there are strategies that can decrease the level of risk you might expect to incur without compromising potential returns. One such strategy you can use in the stock market is covered call writing. All you need to implement this strategy is a discount brokerage account. This short piece will explain what this strategy is and how you can use it to achieve potential returns consistent with the rate of long-term growth in the stock market at reduced risk.

COVERED CALL WRITING IN A NUTSHELL

The strategy entails using stock options (which I explain in more detail later) to, in effect, sell insurance on a stock or exchange-traded fund (ETF): If the stock rises, the insurance buyer keeps the gains, but if the stock falls, you, the insurance seller, must eat the loss. If the stock is flat, you get to keep the money you took in for selling the insurance. As with any deal in which you are acting as an insurer, your profit depends on charging enough so that you will turn a profit even after accounting for the risk you are taking. The reason why I am recommending covered call writing is that over the long term historically, the price of stock market insurance has been high enough to reward those investors who have sold it as part of a covered call strategy. (Future results are not guaranteed, and before you undertake any investment strategy, you need to satisfy yourself that you understand the risks and can afford to bear them in case things do not work out as you planned). Don’t worry about having to find another investor with whom to set up this insurance transaction: Stock and options exchanges are set up to handle the job of matching buyers and sellers at very low cost.

–Marvin Appel. Excerpted from Writing Covered Calls: Earn Investment Income Using ETFs and Stock Options (FT Press Insights for the Agile Investor Series).


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