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Covered-Calls 101

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Using Margin With Covered-Calls

Our new subscribers often ask if we recommend the use of margin in covered-call positions. Before you consider using margin, it's important to be aware of the guidelines brokers have established for this type of trading. To initiate and maintain a margin account, a minimum of $2,000-$5,000 in any combination of cash or marginable securities is required to be on deposit at your brokerage. In addition, margin accounts are obligated to maintain certain minimum equity levels; generally 30% of the portfolio value. If the market value of your margin account declines below that ratio, the broker may request that you deposit more collateral through a "margin" call. A margin (maintenance) call should always be answered promptly with the delivery of additional securities or funds to avoid liquidation of portfolio holdings.

If you are one of our regular readers, you know that our favorite covered-call plays are generally very conservative and almost always "deep-in-the-money." We focus on this method because our primary goal is to provide positions that generate consistent, acceptable returns while still receiving an above-average amount of downside protection. Buying stock on margin in a covered-call position is an excellent way to enhance profit potential when the technique is used correctly. The advantage of trading on margin is that your gain is a successful position is doubled. The downfall lies in the fact that you may be asked to contribute more collateral to the brokerage account should the value of your stock decline significantly. With our in-the-money approach to writing covered-calls, we do not expect you to own the stock at the end of the strike period and that is the primary reason a margin loan is viable for many investors. If you open a new position and the outlook for the underlying issue turns negative (falls below technical support or a recent trend-line/moving average), we recommend you consider closing or adjusting the play to preserve capital. As with any investing strategy, the key to success is to monitor your positions closely and use sound judgment (no emotions!) when making decisions. If you follow this practice, the draw-downs from losing positions will always be kept to a minimum and your remaining funds can be moved into other, more profitable plays.

Brokers and Commissions

Regarding the best stock and option brokers, we can't make specific recommendations because of our current affiliations with some companies. In addition, they all have their benefits and disadvantages, so it is important for you to carefully evaluate the differences and choose the one that best fits your trading needs.

These websites will help you review the different features and limitations of each online brokerage:

http://www.investorlinks.com/directory/3/48/index.html

http://www.smartmoney.com/brokers/index.cfm?story=2005-intro&nav=dropTab

http://consumercenter.jdpower.com/cc/rd/cc/finance/ratings/online_investment/index.asp

http://moneycentral.msn.com/content/Investing/Startinvesting/P98893.asp

Then visit the chat sites and message boards such as:

http://messages.yahoo.com/yahoo/Business_and_Finance/

http://moneycentral.msn.com/community/message/board.asp?board=StartInvesting

for other trader's experiences. With regard to overall popularity, Ameritrade, Brown & Co., E-trade, Interactive Brokers, Mr. Stock, E-Schwab, OptionsXpress, and ScoTTrade seem to be the most commonly used brokerages among the readers of this newsletter.

As far as commissions, we do not include the cost of trading in the return on investment calculations because different brokerages charge varying commission fees and with discount online brokers, the overall effect on most positions is minor. For example, one popular broker charges $17.50 to trade 10 option contracts. On a 1000 share/10-contract position, this represents a cost of only 3.5 cents per share. Obviously, that's a relatively small amount for most option-trading strategies, but commission costs are certainly a crucial part of the risk/reward calculation with in-the-money covered-calls, thus it is important to understand how they affect the potential gain of each position.

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