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When covered calls work, they seem great. However, there is a chance that the stock will tank, turning the 5% profit into a 50% loss.

What are some ways of mitigating the risk of a stock dropping when writing covered calls?

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Two ways to mitigate this risk are to buy a put at a lower premium to the written call, or manage your trade by buying back your call if you see the underlying price going against you - a bit similar to having a stop loss.

  • Or buy a put at the same strike, but further out in time. (a Calendar) – Optionparty Aug 25 '14 at 18:38
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    Note that lowering risk, almost by definition, means lowering reward. – keshlam Nov 28 '14 at 15:33
  • @keshlam - it is about managing your risk. If you want lower risk in general then don't invest in the stock market put your money in the bank. Also, the best ways to lower your returns is to diversify just for diversification and DCA. In fact both of these actions can not only reduce your returns but also increase your risk. – Victor Nov 29 '14 at 20:33
  • @victor: We agree that it's a matter of picking your risks. I'm just making the point that anything you do to reduce the potential risk of an option is going to also reduce some of the potential profit of the option, eventually (ideally) coming back to the same thing as simply investing directly in the underlying security. Pick your poison... – keshlam Nov 29 '14 at 22:14
  • @Optionparty: can you elaborate when you would use a collar and when you would use a calendar? – Victor123 Apr 2 '15 at 22:42
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If the position starts losing money as soon as it is put on, then I would close it out ,taking a small loss.

However, if it starts making money,as in the stock inches higher, then you can use part of the premium collected to buy an out of money put, thereby limiting your downside. It is called a collar.

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