February 27, 2024

Understanding the straddle and strangle strategies

3 min read

A covered call is an options trading strategy involving selling a call option while holding an equivalent number of securities. In simple terms, it means owning the stock and then selling a call option on that same stock. This strategy aims to generate additional income from the premiums received from selling the call option.

Many traders in Singapore use covered calls to enhance their portfolio returns and mitigate potential losses. While it may seem like a straightforward strategy, there are certain things every trader should know before implementing it. This article will discuss essential aspects of covered calls that traders must know in Singapore.

Understanding the basics of covered calls

To fully understand covered calls, it is crucial to have a basic understanding of options trading. Options are contracts that allow the buyer to buy or sell a security at a specific price within a set period. There are two types of options – call options and put options.

A call option gives the holder the entitlement to buy a security, while a put option gives the holder the entitlement to sell a security. Covered calls involve selling call options, which means traders have already purchased the asset and are using that as collateral for the options contract.

The primary objective of covered calls is to generate income from premiums received by selling call options. In exchange for this premium, traders give up potential gains beyond the call option’s strike price. Therefore, if the stock price rises above the strike price, traders must sell their shares at the set price.

One key advantage of covered calls is that they provide downside protection if the stock price decreases. The premium received from selling the call option helps reduce losses.

Selecting the best stocks for covered calls

When implementing a covered call strategy, it is crucial to select the best stocks. Traders should look for stable and high-quality stocks they will hold for an extended period.

Highly volatile and speculative stocks should be avoided as they carry a higher risk of significant price fluctuations, making it difficult to predict the outcome of the covered call strategy. Considering upcoming events or news that could impact the stock price is also essential.

It is crucial to select stocks that have a liquid options market. Therefore, there are enough buyers and sellers in the market, ensuring easy execution of trades and fair pricing of premiums.

Analysing potential returns and risks

As with any investment strategy, traders must analyse the potential returns and risks associated with covered calls. The maximum profit for a covered call is limited to the premium received from selling the call option. However, this premium can significantly enhance portfolio returns if executed correctly.

On the other hand, losses on a covered call are limited to the difference between the stock’s purchase price and its current market value, plus the premium received. Considering these potential risks carefully before implementing a covered call strategy is crucial.

Traders should also analyse the potential impact of market volatility on their portfolios. If the stock price experiences significant fluctuations, it could result in losses that may outweigh the premiums received.

Understanding strike prices and expiration dates

When trading covered calls, traders must also understand strike prices and expiration dates. The strike price represents the predetermined value at which the security is bought or sold upon exercising the option. The expiration date is the period within which the option must be exercised.

Traders must carefully select strike prices and expiration dates based on their risk profile and market expectations. A higher strike price means a lower premium and a higher likelihood of retaining ownership of the underlying stock.

Similarly, a shorter expiration date means a lower premium and less time for the stock price to increase. Traders must balance these factors adequately based on their investment objectives and market analysis.

Tax implications of covered calls

In Singapore, covered call income is taxable, similar to any other investment income. Traders must declare the premiums received from selling call options as part of their income and pay tax accordingly.

However, traders may receive favourable tax treatment for covered calls in certain situations. For example, if the underlying stock is held for more than six months before implementing the covered call strategy, any profits from the stock sale may be exempt from tax.

It is essential to consult with a financial advisor or tax professional to understand the specific implications of covered calls on personal taxes in Singapore.

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