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An Options Strategy That Can Help You Add Yield While Reducing Your Risk

In 2018, it’s harder than it’s ever been to gain a competitive advantage on the market and generate “alpha” in your account.

Thanks to dramatic advancements in computing speeds and information technologies, portfolio managers and traders now have access to data and information that is more accurate, reliable, and timely than ever before, allowing them to make split-second decisions on what stocks to buy, sell, and hold.

Not to mention that if you happen to be a do-it-yourself (DIY) investor or retiree, you find yourself competing, literally, with huge financial institutions employing hundreds and thousands of staff, additionally with direct access to management of the companies that they are making investments in.

The result is an incredibly efficient market.

But thankfully, thanks to advancements made by the financial industry over the past few decades, the everyday investor now has access to new investment strategies that can help them fight back and get back an edge on the competition.

That edge is options, or derivatives trading.

Derivatives get a bad rap in the financial press, and perhaps rightfully so.

Many critics claim that derivatives are overly complex financial instruments that are poorly understood and stand to threaten and do harm to the financial system owing to their unregulated nature.

However, those criticisms are only partially true and speak mostly to derivatives contracts that are traded “over the counter.”

Meanwhile, there are some fairly straightforward options strategies you can use in your account that don’t carry a lot of risk, provided you have a basic understanding of how options work.

Using a covered-call strategy

A covered-call strategy is a very low-risk strategy, whereby you can write a call option on a stock you own, hoping to collect the premium that you can add as income to your account in the same way a dividend would.

Essentially, as the price of the stock you own approaches your target price or estimate of fair value, you would sell a call that has the “strike price” equal to the price where you would be a happy to exit your underlying position.

For example, if you held the stock of Toronto-Dominion Bank (TSX:TD)(NYSE:TD), which traded at $69.97 entering Thursday, and you would be more than happy to part with the shares for $75, then you could write, or sell, the 75-strike options.

If the stock were to rise past the “strike price” of your call options, you’ll be required to sell your shares at the strike price; if the stock does not pass through your strike price, you’ll get to keep the entire value of the premium you received for writing the call, provided you hold it to expiration.

While writing a call by itself — referred to as a “naked” call — is an extremely risky venture and should only be attempted by experienced veterans, a covered call as outlined above is a far different strategy altogether and is in fact considered to be very conservative.

Conclusion

Notwithstanding, option contracts have several features associated with them that require a very careful and detailed understanding.

Before you get started, the first thing you’ll need to do is get in contact with a registered financial advisor and find out if this strategy is right for you.

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Fool contributor Jason Phillips has no position in any of the stocks mentioned.

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