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Covered-Calls 101

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Trading Options in a Volatile Market

Volatility can create tremendous profit potential for derivatives traders. Not only do active markets provide better entry and exit opportunities but large, atypical changes in share values often translate to higher premiums for those who sell options. At the same time, unexpected volatility in the underlying issue can generate excessive risk and make it difficult for traders to establish positions with multiple components such as spreads or combinations.

Anyone who has attempted to trade a fast-moving market knows the difficulties present in that kind of environment. Extreme price fluctuations, heavy exchange volume, and delayed quotes all work together against the retail market player. For the investor trying to lock-in a favorable basis in their covered-call position, it can seem like an impossible task. Thankfully, there is an entry technique that benefits from market volatility and, in many cases, increases the probability of achieving a favorable risk-reward outlook.


"Target-Shooting" with Covered-Calls

Most traders are familiar with the term "target-shoot" when it is used with regard to buying equities and options. For those of you who are not, it simply means to place a limit order that will be filled only if the issue moves some distance from the current price or trading range. The strategy takes advantage of occasional extreme gyrations in stock prices that occur so briefly as to prevent timely execution with market orders.

For covered-calls, this method of opening a new position involves placing a buy-write order at a price less than the current market and hoping for a dip or whipsaw to initiate the transaction. Recall that a buy-write involves the purchase of stock, whilst simultaneously writing a call against that security. When placing a buy-write order, you are requesting to buy the underlying issue and sell a particular option for a stipulated "net" debit. Since the cost basis is predetermined, a buy-write order is the easiest way to establish a specific risk versus reward outlook for the position. The key concept in this process is the use of market movement to enable trade execution. A floor broker or specialist will fill the order if the specified net-debit can be achieved through any combination of stock and option prices.

Depending on the market environment, you may have to wait a few days for a tradable dip. Fortunately, the range-bound conditions prevalent in recent months are certain to resume, so there will always be opportunities to use this technique. Of course, traders who employ the target-shooting method may open fewer plays because many of their orders will be not filled. On the other hand, positions which are initiated in this manner will have better profit/loss potential because there is no possibility of "slippage" during the transaction. Slippage is normally defined as the difference between estimated and actual trade prices however in this case, it refers to a loss of premium in the call option before it is sold. This problem occurs frequently with the plays offered in the CCS portfolio as many are opened in the first hour of trading on the Monday after the new candidate list is published. If too many calls are sold without any buying pressure, the option bid quickly drops towards intrinsic value, making the covered-write strategy unfavorable. Those who attempt to "leg-in" to these positions (buying the stock with plans to write the call later) are often surprised to see the previously overvalued premiums disappear before they can sell the options that complete the play.

In short, the buy-write order can help a trader establish a covered-call position at an acceptable risk-reward ratio without the possibility of transaction-related losses. Neither the stock nor option prices have to be monitored during market hours as the order will be executed only when the appropriate net-debit is achieved. The strategy benefits from market volatility and the latest trading technology as it provides the broker an opportunity to fill the request based on orders from different exchanges. Finally, the buy-write works well with illiquid issues and it is invaluable when used with volatile stocks that less experienced investors might otherwise avoid in a conservative portfolio of covered-calls.

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