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Covered-Calls 101

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Covered-Calls: A Great Way to Start Trading Options!

If you are relatively new to options, you probably think they are very risky. However, you also know that people regularly make money trading options. What makes these individuals successful while others fail? As a group, profitable traders have a number of things in common, the most important of which is a sound and sensible strategy for participating in the derivatives market.

Studies suggest that most investors have very little experience with equity- and index-based options. The data also reflects a general lack of knowledge across the entire spectrum of derivatives trading, even with regard to the most conservative strategies. Despite this historic aversion to options, there is no reason for less experienced traders to avoid covered-calls. In fact, the great thing about writing covered-calls is almost anyone can become an expert with this strategy, no matter how limited their experience.

Writing covered-calls is a good technique for beginners for a number of reasons, not the least of which is its proven performance advantage when compared to outright stock ownership in the majority of market conditions. The technique is also easy to understand and on a relative basis, it doesn't require much time to manage because once a position is open, you can place closing orders at key technical points in the price range of the underlying issue to initiate exit trades. Those who like to watch the financial markets on a regular basis can monitor a stock for changes in trend or character, using a mental stop to close or adjust their position.

Although the strategy is more conservative than simply buying the underlying shares, losses will occur and a painful lesson will transpire the first time you delay the exit from a losing trade. After you have been around the options market for a while, you will learn that it doesn't matter what technique you use; losses are simply part of the game. Indeed, one problem new traders must quickly overcome is learning to close losing plays early, while the capital drawdown is still relatively small. The simple truth is there is no good reason to stay in a losing position when there are so many other viable plays that deserve your time and money. The best (and most profitable) solution is to accept your losses, learn from your mistakes (and evaluate each one critically), then move on! Success will not come immediately so you must have patience and continue to work hard, learning the fundamentals of the options market and gaining the skills that other profitable traders exhibit on a daily basis. Too many new investors give up after a few losing plays, long before they have time to learn (and absorb) the various methods required for profitable trading.

Once you understand that losses are simply part of doing business, you can move on to the "nuts and bolts" of portfolio management. With covered-calls, the key to success is keeping losses to a minimum because there are never any big winners to offset the big losers. This limited-profit outlook is also the reason why correctly managing your positions is one of the most crucial requirements for earning consistent income. As mentioned earlier, successful traders have a number of common traits and by the same token, there is a good explanation why the majority of people lose money with options. Most of them have yet to learn the #1 secret of profitable trading: The market will always prevent the uneducated masses from making money while continually rewarding the astute professional minority. If this is the case (and I assure you it is), the first priority for new traders is acquiring knowledge. Buying and selling stocks may be a straightforward technique but when you add options to the mix, the game becomes much more complex. A successful trader must completely understand any strategy being used, including its advantages and weaknesses.

Obviously, you can't make good decisions without knowing the mechanics of a specific technique and the best traders are those who are acutely aware of how to overcome the shortcomings of their particular approach. Since limiting losses is the principal objective for covered-call writers, it stands to reason that every position should have a predetermined exit point. The majority of market professionals use protective stop-loss orders with their positions, but the retail trader is far less proficient in this practice. Using stop-loss orders eliminates the risk of emotional or reaction-based judgments in difficult situations and removes fear, hope, and greed from the entire equation. The consistent use of stop-loss orders also provides a mechanical and disciplined method for achieving profits. While it may seem strange to a novice player, allowing the market to initiate the closing trade is much more precise than relying on our complex human intuition.

Just as setting trading stops on each individual position is an absolute must, a maximum allowable loss must be considered when managing a portfolio of positions. The rule here is simple: Never trade with more money than you can realistically afford to lose and always maintain a reasonable cash reserve. When establishing position size and collateral requirements, always ensure that funds for active trades are not co-mingled with capital for other functions. It is also very important to set a loss limit at the beginning of each month or option expiration period. When this level is breached, trading should be halted for the duration of that period. Of course, if your losses are consistently more than your gains, stop trading! Step back and take a few days off. When you are ready to try again, evaluate your current approach and review the steps that will be taken to avoid losses. When you begin to earn some money, put a portion of the profits in a reserve account, just in case there are any unexpected developments in the future.

Next week, we'll discuss stock selection and entry strategies, as well some common adjustment techniques for covered-call positions.

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