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Covered-Calls 101

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Ratio-Call Repair Strategy

There are a number of ways an investor can react when the share value of a portfolio holding declines. The easiest approach is to simply take no action and hope the stock eventually recovers. Another common practice is to average down, which involves adding new shares to the current position at a lower price. While this method is a good way to lower the overall cost basis in the issue, it also significantly increases the amount of money at risk in the position. Possibly a better method, and one that option traders often favor in this situation, involves using a call-debit spread to lower the break-even or basis of the overall position while increasing its profit potential. In the book "Options for the Stock Investor", the author refers to this strategy as a: covered-call plus a call-debit spread, where the money from the sold options is used to offset the cost of the long calls. The term ratio-call repair strategy is another, slightly different definition that some position traders use but regardless of how the strategy is labeled, it can be a favorable technique.


A Brief Example

At some date in the recent past, an investor buys 1000 shares of ABC stock at $23.00 and writes (10) JAN-$25.00 calls for a credit of $1.00 per contract. The resultant cost basis in the issue is $22.00. At the end of the January expiration period, the stock has fallen to $17.00, a realized loss of $5.00. Even though the share value has declined substantially, he still likes the long-term outlook for the issue. At the same time, he is concerned about further downside risk and needs to recover lost profit potential. Using options, the investor could attempt to improve his overall position by purchasing (10) AUG-$17.50 calls and selling (20) AUG-$20.00 calls. The new position would be a combination of a covered-call and a bull-call spread. The components are:

1000 shares ABC stock; Cost Basis = $22.00
Long (10) AUG-$17.50 call options ASK = $1.85 per contract
Short (20) AUG-$20.00 call options BID = $0.90 per contract

Notice there are no "naked" or uncovered calls and with simple analysis of each individual component, it becomes apparent that this technique offers an excellent remedy for restoring lost profit potential at a reasonable level of risk.

Since the cost of ten (10) AUG-$17.50 calls and the credit from twenty (20) AUG-$20.00 calls are roughly equal, no extra expenses (other than commission costs) are required for the transaction. However, if there was additional cash invested towards the new position, it would simply raise the "break-even" point (current cost basis) by that amount. Now, if ABC finishes the August expiration period below $17.50, all of the calls will expire. The investor will be no worse off because his cost basis is increased only by any additional money spent for the bull-call spread. In most situations, the amount should be only a small percentage of the stock price (2-5%) or, as in this example, almost nothing. If ABC finishes above $20.00 at expiration, the strategy will yield maximum profit, easily 2-3 times more than a simple covered call. But, keep in mind, it must be structured so as to produce a break-even (or better) result when compared to the original position.

Repair Position Data

ABC Stock

Original cost basis: $22,000 (for 1000 shares)
Current stock price = $17.00 per share
Unrealized Loss = $5,000.00

Call-Debit Spread

Buy 10 calls AUG-$17.50 ($1,850.00)
Sell 20 calls AUG-$20.00 $1,800.00
Net Difference ($50.00)

If the stock finishes the August expiration period at $20.00:

This example of the ratio-call repair strategy would net $450.00 (minus commission costs) as long as the stock rebounded to $20.00 or higher prior to the August expiration date. While that result may not occur, the primary advantage to this technique becomes readily apparent as you compare the outcomes when the stock finishes within the spread strikes. The profit threshold for the new position occurs at a much lower (stock) price and increases exponentially as the value of the underlying issue rises. In addition, the downside break-even point is reduced by roughly the same amount as is invested in the bull-call spread, providing a favorable risk-reward ratio for any capital devoted to recovery effort. Of course, all of the possible outcomes for any particular position can be analyzed by simply comparing the returns at various strikes prices, thus it is very important to do the math (and make sure your calculations are correct!) before you initiate the strategy.

In Conclusion...

Obviously, no one likes to be in a losing trade but the real key to achieving consistent profits is how a person reacts to this type of situation. In many cases, the ratio-call repair technique offers an excellent method to recover lost value in the equity portion of a covered-call position. It is well suited to high quality, long-term portfolio issues that have declined during a bearish market and it may also be useful with momentum-based positions that are currently in a lateral consolidation. Regardless of the type of repair strategy used, investors should carefully evaluate the potential outcomes of each scenario and consider only those alternatives that conform to their trading style, experience level, and available account capital.

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