Option Investor

Covered-Calls 101

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Success With Covered-Calls

The goal of every investor is to have a broad mix of portfolio holdings with reasonable profit potential and acceptable downside risk. For those who write covered-calls, the objectives are similar but with a greater priority placed on preventing large draw-downs. Adept traders can achieve monthly returns as high as 10% with our out-of-the-money candidates however these gains do not come without additional capital risk. In contrast, the conservative, in-the-money positions generally have a higher probability of a favorable outcome and lower downside potential. Regardless of the approach you favor, the effects of unfavorable market activity can be minimized by spreading portfolio capital across a number of positions, all with a predetermined exit (or adjustment) point. To further reduce the possibility of catastrophic loss, an investor can diversify his market exposure by selecting a wide variety of issues for covered-call positions. The stocks purchased should represent companies of different types in an assortment of industries. Many novice traders ignore this principle and consequently, their losses are substantial when a heavily weighted sector falls "out of favor." Indeed, most experts recommend limiting the exposure of each position to a small percentage (generally no more than 10%) of the overall portfolio value. This is very important to the success of the covered-call strategy because you don't want one issue to have a significant impact on your overall gains. Since no one "really" knows what a specific stock is going to do in the future, position diversity and asset allocation are essential to achieve consistent profits with this strategy.

The next critical components of a successful covered-call portfolio are comprehensive research and effective money management. Once you have a candidate in mind, do your homework! Study the company and its calendar including upcoming events, earnings dates and any other scheduled reports. Prior to executing a transaction, know exactly what the break-even (cost basis) point is, and be prepared to take action if the underlying issue reaches that price range. After you take a position in a particular issue, stay informed by monitoring all the news and announcements affecting the parent company. Observe the daily progress of your stocks and realize that you have the ability and control to adjust or close the position at any time. Obviously you do not need to check the prices on an hourly basis, but we do recommend that you review each session's closing quotes. News and public opinion can have a significant impact on a stock's price and unfortunately, it is impossible to research "future" events before you buy an issue. The key to success is to be fully prepared for any occurrence so you can respond in a timely and effective manner.

Although the concepts of most exit and adjustment strategies are relatively simple (and we will cover them in future narratives), there is no such thing as "perfect" position management. With stock and option combinations, the best approach is to evaluate the risk-reward ratio of each possible scenario and implement the strategy that best fits your initial trading plan and (revised) technical outlook for the underlying issue. Success with covered-calls lies in one objective; a consistent flow of monthly income with limited portfolio risk. Any position that becomes unfavorable due to changes in the fundamental or technical characteristics of the underlying issue should be removed from the portfolio before it can generate significant deficits. Catastrophic failures are not unavoidable but they should be managed to reduce the effects of the shortfall. At the same time, there will be occasions when issues fail without warning, leaving no opportunity for exit or adjustment. In the stock market, unexpected events simply occur; earnings warnings, shareholder lawsuits, negative news in the industry or sector and changes in public sentiment. All of these activities can affect the success of an individual position but with a properly allocated and diversified portfolio, the long-term effects are minimal.

The most difficult lesson for a new trader occurs when it becomes necessary to close a losing trade. Indeed, it is very hard to learn to exit unsuccessful plays in a timely manner but the simple fact is, there is no reason to hang on to a losing position when there are so many other profitable plays that deserve your time and money. Accept your losses, learn from your mistakes (evaluate each one critically) and move on! Losses are inevitable with any investment strategy and instead of being surprised, you must anticipate them. History has proven that a percentage of the covered-write candidates will be unprofitable thus when the situation arises, it is not regarded as a failure but rather an integral part of the system. Further, your portfolio's performance should be evaluated based on the sum of its parts, rather than each individual trade. With this approach success is gauged by growth in account value and the losses become less significant. Indeed, that is one of the principal reasons for entering several positions; it is much easier to identify and act on a potentially negative play when it doesn't have a substantial effect on your overall success.

Until Next Time...

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