Covered call strategies can be useful for generating profits in flat markets and, in some scenarios, they can provide higher returns with lower risk than their underlying investments.

Covered Calls on Leveraged Futures Contracts

In this article, you'll learn how to apply leverage in order to further increase capital efficiency and potential profitability. Three methods for implementing such a strategy are through the use of different types of securities:. While all of these methods have the same objective, the mechanics are very different, and each is better suited to a particular type of investor's requirements than the others.

Covered Call Returns Covered call strategies pair a long position with a short call option on the same security. The combination of the two positions can often result in higher returns and lower volatility than the underlying index itself.

For example, in a flat or falling market the receipt of the covered call premium can reduce the effect of a negative return or even make it positive. And when the market is rising, the returns of the covered call strategy will typically lag behind those of the underlying index, but will still be positive.

However, covered call strategies are not always as safe as they appear.

Not only is the investor still exposed to market risk , but also the risk that over long periods the accumulated premiums may not be sufficient to cover the losses. This situation can occur when volatility remains low for a long period of time and then climbs suddenly. Applying Leverage Leveraged investing is the practice of investing with borrowed money in order to increase returns.

The lower volatility of covered call strategy returns can make them a good basis for a leveraged investment strategy. Of course, applying leverage only adds value when the underlying investment returns are significantly higher than the cost of the borrowed money.

Covered Calls in Margin Accounts Margin accounts allow investors to purchase securities with borrowed money, and if an investor has both margin and options available in the same account, a leveraged covered call strategy can be implemented by purchasing a stock or ETF on margin and then selling monthly covered calls.

However, there are some potential pitfalls. First, margin interest rates can vary widely. One broker may be willing to loan money at 5. As shown above, higher interest rates will cut profitability significantly. Second, any investor who uses broker margin has to manage his or her risk carefully, as there is always the possibility that a decline in value in the underlying security can trigger a margin call and a forced sale. To avoid this danger, most investors would opt for lower leverage ratios;thus the practical limit may be only 1.

Covered Calls with Index Futures A futures contract provides the opportunity to purchase a security for a set price in the future, and that price incorporates a cost of capital equal to the broker call rate minus the dividend yield.

Futures are securities that are primarily designed for institutional investors but are increasingly becoming available to retail investors. As a futures contract is a leveraged long investment with a favorable cost of capital, it can be used as the basis of a covered call strategy.

The investor purchases an index future and then sells the equivalent number of monthly call-option contracts on the same index. The nature of the transaction allows the broker to use the long futures contracts as security for the covered calls.

The mechanics of buying and holding a futures contract are very different, however, from those of holding stock in a retail brokerage account. Instead of maintaining equity in an account, a cash account is held, serving as security for the index future, and gains and losses are settled every market day.

The benefit is a higher leverage ratio, often as high as 20 times for broad indexes, which creates tremendous capital efficiency. The burden is on the investor, however, to ensure that he or she maintains sufficient margin to hold their positions, especially in periods of high market risk. Because futures contracts are designed for institutional investors, the dollar amounts associated with them are high. LEAPS Covered Calls Another option is to use a LEAPS call option as security for the covered call.

A LEAPS option is an option with more than nine months to its expiration date. The LEAPS call is purchased on the underlying security, and short calls are sold every month and bought back immediately prior to their expiration dates. At this point, the next monthly sale is initiated and the process repeats itself until the expiration of the LEAPS position.

Even though LEAPS call options can be expensive, due to their high time value , the cost is typically less than purchasing the underlying security on margin. Because the goal of the investor is to minimize time decay , the LEAPS call option is generally purchased deep in the money , and this requires some cash margin to be maintained in order to hold the position.

By selling the LEAPS call option at its expiration date, the investor can expect to capture the appreciation of the underlying security during the holding period two years, in the above example , less any interest expenses or hedging costs.

Still, any investor holding a LEAPS option should be aware that its value could fluctuate significantly from this estimate due to changes in volatility. The unpredictable timing of cash flows can make implementing a covered call strategy with LEAPS complex, especially in volatile markets. The Bottom Line Leveraged covered call strategies can be used to pull profits from an investment if two conditions are met:.

A retail investor can implement a leveraged covered call strategy in a standard broker margin account, assuming the margin interest rate is low enough to generate profits and a low leverage ratio is maintained to avoid margin calls. For institutional investors, futures contracts are the preferred choice, as they provide higher leverage, low interest rates and larger contract sizes.

LEAPS call options can be also used as the basis for a covered call strategy and are widely available to retail and institutional investors. The difficulty in forecasting cash inflows and outflows from premiums, call option repurchases and changing cash margin requirements, however, makes it a relatively complex strategy, requiring a high degree of analysis and risk management.

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Covered Call Strategies For A Falling Market By Tristan Yates Share. Three methods for implementing such a strategy are through the use of different types of securities: ETFs purchased on margin index futures LEAPS While all of these methods have the same objective, the mechanics are very different, and each is better suited to a particular type of investor's requirements than the others.

The cost of the LEAPS option is, like any option, determined by: The Bottom Line Leveraged covered call strategies can be used to pull profits from an investment if two conditions are met: The level of implied volatility priced into the call options must be sufficient to account for potential losses. The returns of the underlying covered call strategy must be higher than the cost of borrowed capital. The rewards of using LEAP call options can be a lower cost of capital, higher leverage and no risk of margin calls.

Margin loans, futures and ETF options can all mean better returns, but which one should you pick?

How to Write Covered Calls: 4 Tips for Success | Ally

Covered calls may require more attention than bonds or mutual funds, but the payoffs can be worth the trouble. Discover the concept of financial leverage. Learn multiple ways to get leverage in your portfolio, and decide if leverage is a good idea for you. Options are always speculative, but LEAPS provide a longer time frame, which may make them more profitable.

Trading Options on Futures Contracts | Investopedia

The standard covered call can be used to hedge positions or generate income. This calendar spread may do so more effectively. Learn how to multiply returns and diversify risk by buying options instead of stock. Learn how this simple options contract can work for you, even when your stock isn't.

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