Option Investor

Covered-Calls 101

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This week's article is devoted to answering some common questions about the Covered-Calls System.

1) How do you calculate potential gain/profit for covered-call positions?

2) What is a reasonable profit target for investors who use this strategy?

3) Are there some basic guidelines for success with stock and option trading?

First, we will review the common profit (and loss) formulas for covered-call positions.

The calculations utilized to determine potential profit or return on investment (ROI) with covered-calls can be divided into two categories: Return Called (RC), and Return Not Called (RNC). Many traders focus on the RNC when evaluating similar covered-call candidates since there is no assumption made about the movement of the underlying equity. To compute this number, you simply take the net cash received from the sale of one call option and divide it by the cost basis of the position. The cost basis is the price per share of the underlying stock minus the cash received from the sale of one call option contract. (Note: This is also the minimum amount of equity, without using margin, required to initiate the position).

Return Not Called (RNC) Calculation:

Buy XYZ stock for $12.00 per share
Sell MAR-$12.50 call for $0.50 per contract
Cost Basis = $12.00 - $0.50 = $11.50
RNC = $0.50 / $11.50 = 4.3% (stock unchanged at $12.00)

For in-the-money (ITM) positions, determining the Return Called involves a similar process. The maximum profit is equal to the price of the sold option minus the difference between the cost of the stock and the option strike price. As you would expect, the in-the-money RNC is the same as the RC, since the sold (call) strike is below the stock price. Regardless of the share value, this is the maximum return on investment.

In-The-Money RC Calculation:

Buy XYZ stock for $12.00
Sell MAR-$10.00 call for $2.50 per contract
Cost Basis = $12.00 - $2.50 = $9.50
Max Profit = $2.50 - ($12.00 - $10.00) = $0.50
RC = $0.50 / $9.50 = 5.26% (stock unchanged at $12.00)

For out-of-the-money (OTM) positions, the RC can be substantially higher than the RC, depending on the movement of the underlying issue. In this case, the maximum profit is equal to the price of the sold option plus the difference between the cost of the stock and the strike price. When the stock price increases, the RC moves up as well, until the sold (call) strike is in-the-money. In contrast, the RNC does not increase because it based solely on the cash received from the sale of the option (and assumes the stock price remains unchanged).

Out-Of-The-Money RC Calculation:

Buy XYZ stock for $12.00
Sell MAR-$12.50 call for $1.00 per contract
Cost Basis = $12.00 - $1.00 = $11.00
Max Profit = $1.00 + ($12.50 - $12.00) = $1.50
RC = $1.50 / $11.00 = 13.64% (stock at or above $12.50)
RNC = $1.00 / $11.00 = 9.09% (no benefit from stock appreciation)

After the potential return on investment is ascertained, the process can be carried one step further to provide a better basis for comparison. This involves converting the gain or ROI to a monthly time-frame. Using the ITM-RC example above, a 5.26% profit earned in a 3-week (21 day) period could be characterized as follows:

ROI = 5.26 / 21 days X ( 365 days / 12 months) = 7.61% per month

Essentially, the return is annualized and divided by twelve to produce a monthly basis. This helps investors to visualize the value of compounding a seemingly small return over and over again. Of course, commission costs are not included in the ROI calculations as they vary depending on which brokerage and what level of service is provided. In addition, the purchase of common lot sizes such as 500 or 1000 shares will negate much of the impact of this expense.

Position Selection: More Profit = More Risk!

All of the candidates in the Covered Calls System are selected with one goal: achieve favorable gains on a diverse group of stock holdings while providing reasonable downside protection against unexpected market activity. Since this strategy can easily be tailored to either an aggressive or conservative market outlook, we provide two basic categories of plays. The primary purpose of the aggressive (ATM/OTM) portfolio is to profit from the capital appreciation of stocks in a bullish trend. The success of this approach is based almost entirely on the movement of the underlying issue, however the cash received from the sale of call options reduces the overall cost basis, thus improving the chances of a profitable outcome. In the conservative (ITM)portfolio, the objective is geared more towards the average investor; it seeks to identify positions that have a high probability of making an acceptable (and consistent)profit. Using this methodology, it is reasonable to expect to achieve gains of 2 to 4 percent per month, when averaged on a yearly basis.

Although the covered-call strategy is often used in conjunction with long-term stock ownership, we favor positions where success isn't predicated on forecasting an issue's directional trend for extended periods. Remember, writing covered-calls will provide a small hedge against downside movement in the stock but the technique is not a remedy for protracted bearish activity. The use of the strategy is always predicated on a neutral to slightly bullish outlook for the underlying equity and its associated sector/industry group. In addition, selling covered-calls requires a disciplined approach and sound money-management techniques as there is risk of loss in all forms of stock and option trading. As with any investment recommendation, it remains your responsibility to perform due diligence and thoroughly research each issue you are interested in adding to your portfolio.

Trading Guidelines

As most of you know, the market has been rather difficult in recent weeks and the deluge of conflicting outlooks and forecasts has demonstrated why each of us must work hard to overcome our emotions and think independently. At the same time, it is also important to reflect on our previous failures and use that knowledge to avoid the same mistakes in the future. Here are some important concepts professional traders have identified from their past trading experiences:

1. Trading demands foresight, flexibility, patience, common sense and above all, sound judgment executed in a timely manner.

2. Distribute risk with portfolio diversity, and avoid financial uncertainty with hedged positions.

3. Trade with a plan, and know your limits before you open any position! Always predetermine each entry and exit target.

4. Manage your losses successfully and profits will soon follow!

5. Don't be influenced by outside forces, including friendly advice. Ignore the crowd and think for yourself!

6. When hope becomes a major part of your outlook, it's time for a break. Fall back, take inventory, redefine your motives and try again.

7. Momentum traders: Buy on weakness, and add to your position as the rebound above a trend-line (or moving average) confirms the upside potential.

8. Momentum traders: Sell on strength, and close out winning positions at the first sign of hesitation. Protect your profits with trailing stops.

9. Don't over-trade! In addition, be careful not to increase your trading activity after a string of winners - savor your success (and your money!)

10. Whenever you expect something to occur, remember that the market is famous for doing the unexpected.

Trade Wisely!

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