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Reducing Cost Basis with Covered Calls

Welcome back to the series on reducing cost basis. If you missed the first two articles, I highly recommend checking them out to get the full picture of this concept.

We've already covered why reducing your cost basis is essential and discussed a straightforward method for determining where to buy shares. Today, we're diving into the world of covered calls, with a quick overview of what a covered call is, why I sell covered calls and how I decide when to sell my covered calls.

A covered call is an easy and 'safe' strategy you can use to reduce your cost basis once you own 100 shares of a stock. By selling this call you are agreeing to sell your 100 shares to someone else if the stock hits that price. It's called a "covered" call because you have the shares to back up your agreement.

Please note: this strategy only works if you have 100 shares. If you're just starting out with a smaller account, your goal should be to work your way up to being able to own 100 shares (ideally of a few companies for diversification). Without 100 shares of stock selling a call would mean you are selling "naked" calls, and that's a high-risk trade you should avoid!

So, what's the deal with covered calls? Essentially, when you sell a call option, you're making an agreement to sell your 100 shares of stock at a price you've chosen before a specified date. In return for this agreement, you receive an upfront payment known as the premium. Think about covered calls like renting out your shares with an agreement to sell at the price you choose. If the stock doesn't hit that price in time, you keep your shares and you keep the premium they paid you, just like a landlord keeps the rent.

I also think of this premium like an extra dividend. In fact, I sell calls more frequently than most of the dividends payments I receive from my stocks. Many stocks pay dividends one a quarter, I usually sell calls on a monthly basis, although depending on my overall strategy and the stock I'm trading, I might go as frequently as weekly!

The reason covered calls are described as a safe options trade is the primary "risk" you take is capping your upside potential. You will see this in the next article when we jump back into the CAH trade I took. In simple terms, if the stock skyrockets, you've agreed to sell it at your chosen strike price, potentially missing out on more significant gains. But remember, locking in a profit is never a bad thing – trying to catch the very peak of a stock's rise can lead to disappointment.

To maximize your premium while minimizing your risk, I pay close attention to the stock's candlesticks. If it struggles to close above its moving averages, I get more aggressive with selling calls. There are times when I will sell calls below my actual cost basis. If the stock is in a strong downtrend.

However, when the stock is in a bullish trend, I wait for at least three up days and/or for the stock to approach a resistance before I sell a call. This is not time intensive, Remember you can and should set alerts to notify you when your stock is near resistance, allowing you to maintain a balanced life.

The reason I often wait to sell a call is bullish moves yields more premium compared to down day. I used to sell 25 delta covered calls randomly, and this worked pretty well. But over time, I've discovered that timing my calls more strategically enhances the premiums I collect, which, in turn, accelerates my cost basis reduction by bringing in more income.

Remember, the goal is not to complicate things but to make this strategy work for you in the simplest, most efficient way. It's all about maximizing those profits while minimizing your risk and workload.

We will jump back into the CAH example next! If you want more information you should join the GKT discord to discuss these tips in more detail and connect with like minded people who trade the stock market! Happy Trading Good Kids!

Disclaimer: this is NOT financial advice. I’m basically just some dude on the internet who’s been trading a while, and I use the stock market as my primary source of income. None of this is financial advice it’s purely educational!

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