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Covered-Calls 101

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Covered-Calls: Strategy Review

Many of our readers write covered-calls on long-term portfolio holdings, so we thought it might be a good idea to offer some suggestions on how best to approach that strategy. For most investors, the primary concerns include which type of options (ITM/ATM/OTM) to sell and the length of the expiration period. Other common questions involve the probability of early assignment and potential adjustment techniques for in-the-money options.

Selling covered-calls is one of the most popular option trading strategies among conservative investors because it offers a method to generate additional income from portfolio holdings. Since this income lowers the overall cost basis of the position, it helps reduce the risk of stock ownership. The amount of money produced by the sale of a covered call depends on many factors, however the distance between the sold (call) strike and the current price of the underlying issue has the most significant effect. Writing in-the-money calls results in greater cash inflow yet it also increases the risk of being "called" and possibly having to sell the stock for a loss. In contrast, selling out-of-the-money calls produces less upfront cash but offers more upside (capital gain) potential along with a relatively low probability of assignment. The majority of in-the-money covered-calls are very conservative as the resultant cost basis is generally some distance below the current price of the stock. Not surprisingly, out-of the money calls are more speculative because the overall position depends more on stock price movement and less of the benefits of writing the call. This condition prevails regardless of the current market trend because the value of the out-of-the-money call is relatively small, providing little downside margin if the underlying stock declines.

When choosing which call to sell against a long-term holding, many experienced investors focus on at-the-money strikes because they offer a favorable balance between upside potential and downside safety in the combined position. If the implied volatility in a particular series is extremely high, the investor may be able to move further in-the-money, using the inflated time value (premium) to establish a more conservative risk-reward outlook. The key to choosing the most optimum strike price lies in a comparison of the various option series and their related prices. This process will reveal the best combination of risk (based on cost basis) and reward (at maximum profit) for a specific issue and outlook. With regard to the appropriate expiration period, the best strategy is to sell a small amount of time, over and over, rather than a large increment on an infrequent basis. In spite of this fact, it is unlikely the investor will be able to write front-month options on a consistent basis because option premiums on stable, high quality issues are generally less robust. In fact, most investors will probably need to focus on options in the second and third expiration months, in order to receive an acceptable credit for the sold calls.

One of the biggest concerns for an investor who writes covered-calls against long-term portfolio stocks is the possibility of early exercise of the sold (short) options. If the share value rises substantially after the calls are written, the easiest way to avoid assignment is to adjust the position by "rolling" the calls up to a higher strike price. When an investor rolls up (repurchases the sold calls and sells higher strike calls), he increases the profit potential of the position. The catch, of course, is he also surrenders downside protection. The new (downside) break-even point is increased by the amount of money required to complete the roll-out transaction; the cost of closing the sold calls minus the proceeds received for selling the new calls. Because this procedure incurs a debit (placing more money at risk), it is generally not a favorable technique for conservative investors. One way to overcome this effect is to roll both up, and out, to a future expiration date in the sold option. Selling a longer-term option will help reduce the cost of the transaction and possibly yield a credit in the process.

Investors who want to hold on to their stock "at all cost" may deem it prudent to initiate the adjustment process as soon as the sold options are in-the-money. Keep in mind, however, there is very little risk of early assignment when there is time value (premium) remaining in the price of the sold calls. Recall that the premium of an option can be plainly defined as any value beyond the intrinsic value. This component of an option's price is beneficial to the option writer because it decays on a daily basis and the closer the option gets to the expiration date, the faster its time value decays. Considering the consequences, when the option moves deep in-the-money and/or the expiration date is near, it may be best to roll forward to reduce the likelihood of the short options being exercised. The investor can repurchase the sold calls and sell new, longer-term calls, either at the same strike price or in a different (higher/lower) series, whichever is consistent with the current outlook for the underlying issue. From a historical standpoint, the percentage of options exercised prior to expiration is very low but when the time value falls to zero (and the option is bid at parity or a discount), there is a much higher probability of position arbitrage by market-makers. An investor who encounters this situation should act quickly to prevent an unanticipated loss of his stock and quite possibly, his future capital gains.

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