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Posts Tagged ‘covered call trading’

Compounding Returns with Option Selling

You have undoubtedly heard it said before – compounding returns is the eighth wonder of the world or man’s greatest invention. But to an investor it is a great wealth builder. While many income investors think of compounding dividends, this can also be accomplished by option sellers by compounding the option premium received by selling either put or call options. I think about the premium received as soon as the option is sold can be readily reinvested or compounded immediately.

Here is the formal definition from Investopedia:

Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding; the higher the number of compounding periods, the greater the compound interest.

The “Rule of 72” is an easy way to calculate how long it will take to double you money based on compounding returns. For example, an investor has a dividend stock paying an annual 5% dividend. Using the rule of 72, dividing 72 by 5 indicates the investor will double his money in 14.4 years. Not bad for a dividend producing asset. Now, let’s compare this to selling options. If you make 2% per month on average, you can double you money in 36 months (72/2=36). This is only 3 years compared to 14.4 years for the 5% dividend stock! Which investment do you want to pursue?

This is the theory behind our strategy to sell puts and covered calls at get rich investments. We can generate consistent income on a monthly basis that will provide us the opportunity to compound our money and returns at a faster pace than the buy and hold dividend investing.

Learn how to compound your money and the best stocks to use in this strategy to double your money.

Get started today with the Monthly Income Report.

When To Take Action with Covered Calls

The basic covered call trader will write a call and wait until it expires then decide what action to take next.  I suggest that you monitor your position and determine what changes to make before expiration to enhance your profit or decrease your downside risk.

For the call writer with less time who does not have the time to monitor the position, you have 2 options to negotiate the market action:

  1. Determine the price you want to close the position and then set an automatic stop order.  For example, you entered a covered call and you do not want to let the stock decline so you enter a stop order to but the sold option at market and then sell the stock with both events triggered by your predetermined stock price.
  2. Let the option go until expiration and then make your next move.  This strategy does not mean you will lose money but you will keep selling calls to minimize any stock price decreases over time.

Now, for the more active covered call trader, here are 2 actions to increase your trading profits:

  1. If the price of any option you sold declines to a small amount, then buy the option back to lock in profits on the option.  If the option price drops to 25 cents per share or less, then you can buy it back with the different between sold option price being a profit.
  2. The second option is to watch the time value of an in-the-money option and buy it back when the time value gets low.  the rationale is that you have made most of the profit already as time value can only go to zero.  If there is only 10 or 20 cents left, you can buy to close and sell another option for more premium income.

There is no right or wrong strategy based on these two methods to trade covered calls.  You should decide if you fall into the first scenario (less monitoring) or the second (more activity) based on your time commitment to your covered call trades.  In a later post, I will discuss my way of trading covered calls based on a strategy that takes option obligation and stock price into consideration.

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