Option Investor

Covered-Call Fundamentals

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How to Initiate a Covered-Call Position:

There are two basic approaches to writing a Covered Call:

1) Sell call options against stock that is already owned.

Buy shares of a specific stock and simultaneously sell an equivalent number of call options against it. This strategy is often called a "buy write" and it has a number of advantages but most importantly, it guarantees the opening trade will be expected only when it meets specific criteria with regard to stock price and option premium.

Understanding the Buy-Write:

When placing a buy-write order, you are requesting to purchase shares of stock and sell call options for a specific "net" price, with both transactions occurring at the same time. Since the cost basis is established prior to the trade, a buy-write order is the easiest way to initiate a new covered-call position. The exact phraseology (when speaking to an account representative) is not important but a "net-debit" must be given when the trade instructions are delivered to the agent. The floor broker or clearing-house will fill the order if the specified net-debit can be achieved through any combination of stock and call-option prices.

Using the Candidate Lists:

1) Review the most recent listing on the Portfolios page of the Covered-Calls System at OptionInvestor.com. Here's the direct link to the current newsletter.

2) Choose a group of candidates (ITM or ATM/OTM) that meets your risk versus reward criteria. Some traders may want to focus on more aggressive, momentum-based plays while others will lean towards low risk, easy to manage positions. One you have selected a specific portfolio, review the individual positions offered and conduct some research on the underlying stocks to determine which issues meet your personal investment criteria (fundamental valuation, forecast earnings/profitability, technical character, etc). When you have identified a favorable stock/option combination, decide how many shares you want to purchase (usually a minimum of 500) and place an order with your broker using the "buy-write" technique. Traders who want to submit the order online will need to consult with their individual brokerages for instructions on using specific software platforms.

3) Once the order is in place, it will need to be monitored for execution. If a "fill" is not achieved in the first few days after the position is offered, it may no longer be available at recommended price. At that point, you can either adjust the net-debit to yield a smaller profit or forego the position entirely in favor of a new candidate. Only you can make this decision, based on your individual risk-reward outlook.

4) After the order is filled, the price activity of the underlying issue should be monitored on a daily basis. The objective is to detect any unwanted changes in the stock's technical character in a timely manner. If this occurs, it may be necessary to modify the position to limit the effects of adverse market activity. While a covered-call affords additional downside protection for the stock price, a large decline can rarely be tolerated without capital loss. Occasionally the issue will recover prior to the option expiration date, however the best course of action is to curb losses before they significantly affect portfolio value. In addition, some plays can be closed early for a small (but favorable) gain, thus releasing account funds for a new covered-call position. A variety of position management techniques will be covered in future educational narratives.

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