Option Investor

Covered-Calls 101

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A Strategy for Any Market

Most investors write covered-calls to earn supplemental income on portfolio stocks. The proceeds from the sale of each call option lowers the cost basis in the underlying issue, thus providing additional downside margin for future market volatility. In addition, the risk versus reward outlook for the covered-call can easily be adjusted - with a range from conservative to speculative - by varying the strike price and time-frame of the sold options. This characteristic makes the covered-call one of the best strategies for stock owners who initiate and manage their positions across a variety of market conditions.

The aggressive approach to covered-calls generally involves writing out-of-the-money options. The goal of investors who use this tactic is to achieve additional capital gain when the trend of the underlying issue is primarily bullish. Those with a more moderate outlook typically sell at-the-money options, which provide a reasonable cash return and a limited amount of protection against a decline in the underlying share value. Investors who are risk-averse focus mainly on in-the-money calls, as the potential for loss due to stock depreciation is greatly reduced by the substantial option premiums. The latter method seems to work best for the majority of covered-writers, who simply want a relatively steady income stream regardless of the market environment.

Consider this example:

BUY 1000 shares XYZ stock; Ask = $15.00
SELL 10 contracts $12.50 calls; Bid = $2.85
Cost Basis = $12.15
Maximum Profit = $0.35
Return on Investment = 2.88%

Obviously, the credit received from the sale of in-the-money options provides a larger measure of safety (against unexpected declines) than that which is available with at- or out-of-the-money options. At the same time, the capital gain potential is severely limited, demonstrating the primary drawback to this approach. Let's look at how the two components; profit and protection, are affected by different stock prices at option expiration.

XYZ at $10.00 - The loss on the stock position is $2.15 or 17.69%.

The large credit from the sale of the call options is simply not enough to overcome a 33% decline in the underlying share value. However, additional covered-calls can be sold in the coming months to help recover capital losses.

XYZ at $12.15 - This is the cost basis (break-even point) of the position.

The stock has declined 25% and yet your portfolio incurs no loss. You are free to sell the stock (probably a good plan!) or write new calls to further reduce the cost basis.

XYZ at $12.50 - This is price at which maximum profit is achieved.

Your shares will be assigned with the stock above $12.50, so there is no further upside beyond this point. Keep in mind, there has also been no need for appreciation in share value, yet your position has attained the maximum possible return on investment.

XYZ at $12.51 (or above) - This range represents lost potential in the stock.

Your obligation to provide the stock upon assignment limits the gains from capital appreciation to the strike price ($12.50) of the sold call. Above this price, the position endures an unlimited opportunity cost.

Risk Versus Reward

Every covered-call position has less risk than an outright stock purchase, due to the reduced basis in the underlying issue. The sale of in-the-money (ITM) options simply offers a higher probability of a successful outcome because there is no requirement for capital appreciation in the stock. In addition, investors who do not have exceedingly bullish expectations for a long-term portfolio holding may find that the sale of in-the-money call options offers an appropriate hedging strategy during range-bound market cycles. Traders who favor this less aggressive technique should sell calls that yield a potential gain of 3-5% per month with downside protection of at least 10% of the current stock price. Any position constructed with these guidelines should have a relatively conservative outlook (regardless of the trend of the underlying issue) since the large option premiums will significantly lower the break-even point and still provide a reasonable return.

Despite the favorable characteristics of covered-call writing, any form of stock ownership entails risk and even the sizeable proceeds received from the sale of in-the-money options may not provide enough insurance to overcome the worst draw-downs. In fact, one or two catastrophic losers can (and historically do) greatly affect the annualized return for this strategy. There are also some unique obstacles - related to the human emotions of hope, greed, and fear - that new investors encounter when writing in-the-money covered-calls; the most obvious being you won't "get rich quick!" Unfortunately, that shortcoming can alter the performance of this technique because once you have a few winning plays, the desire to achieve slightly higher returns becomes almost overwhelming. Then, after that first "big" loser (that you fail to close early because "it can't go much lower") eliminates most of your gains, it's easy to look for something more exciting and (potentially) more profitable. Of course, the best way to overcome these problems is to utilize proven money-management techniques that preserve capital and limit excessive losses. We'll discuss some of these methods at length in a future segment of Covered-Calls 101.

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