Option Investor

Covered-Calls 101

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Now that our new Covered-Call System is "live" on the OIN website, it's a great time to review the fundamentals of one of the most popular option trading strategies for stock owners.

Why Should YOU Use Covered-Calls?

Investors usually write covered-calls to generate monthly income, collecting money for the sale of an option against a stock position in his or her portfolio. This conservative strategy can be used effectively on all type of stocks as long as the outlook (fundamental and/or technical) for the issue is favorable.

For a novice trader, the primary advantage of a covered-call is the technique is easy to use and the resultant position is more conservative than outright stock ownership. In writing an option on the stock, the investor has partially insured the issue against a future drop in value. Of course, the downside risk in ownership is not eliminated, only reduced. In addition, the actual cost of opportunity loss or potential upside movement can be substantial thus the resultant risk-reward outlook is a "high probability of limited profit." A second benefit to this approach is it allows new investors to learn successful trend-trading techniques with a small margin of safety while managing the combined position for upside profit and downside risk. There are other, more subtle benefits and disadvantages but these are the most common reasons that investors choose (or avoid) this strategy.

In the past, we've received a number of questions regarding the various approaches to the strategy of selling covered-calls. For less experienced investors, we recommend the "in-the-money" covered write as a primary technique for consistent profits. This method is easy to master and works in harmony with a low maintenance, low risk investing style. The principal theory behind this approach is to be "aggressively conservative." This tactic is in contrast to the popular "conservatively aggressive" method used by more experienced traders, where the underlying position is bullish (based on OTM calls) and requires an upward movement from the stock for profit. In general we find that most traditional, long-term investors have an aversion to excessive risk and large losses. Studies suggest (and our past results confirm) that this category of stock owner will achieve greater returns through the steady profits from "in-the-money" covered writing than he/she would using the high risk, high reward tactics of a more aggressive trader.

Those who are new to the "in-the-money" approach may think it is far too conservative to yield favorable gains, however the magic ingredient of the strategy is the power of compound interest. Covered-call writing allows investors to potentially compound their returns on stock ownership each month of the year. Unfortunately, while most people begin writing covered calls with the goal of compounding their money on a monthly basis, many lose focus of the fundamental outlook of the technique (consistent, low risk profits) and begin to concentrate on higher, single transaction returns. This is a common mistake and without adept position management, it can substantially increase risk and the probability of loss.

The market historically offers a 2-4% monthly return for conservative (in-the-money) covered calls but with diligent research and analysis, and proper money management, the margin of profit can be increased. In our low risk (ITM) portfolio, we attempt to establish positions that offer a similar return on investment and even with this seemingly meager profit, the long-term capital growth is excellent, due to the unique mathematics of compounding. Earning 3% per month in a stock-based portfolio, without compounding or margin trading, equates to a 36% yearly return. We have yet to find a bank or CD that matches that rate.

Obviously, most retail option traders regard a 3% monthly return as far too low. In fact, why would anyone want such a paltry reward when the market offers such great potential for increased wealth? There is answer is quite simple: RISK. Any strategy that yields 10% will be riskier (on a purely theoretical basis) than one offering a 3% return. The old adage, "The greater the risk, the greater the reward" is quite accurate. Regardless of this fact, some of you will learn the hard way, just as we did. After getting hammered on a number of aggressive positions in the bear market of 2002, we made the transition to a portfolio of primarily ITM covered-writes with lower returns. Now our account value grows (most of the time) on a consistent basis...

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