Option Investor

Covered-Calls 101

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Why Would Anyone Sell "In-The-Money" Covered-Calls?

Many of our new readers are often confused by this unique method of profiting from stock ownership. Despite its relatively obscure status, savvy investors have been selling in-the-money calls for many years. The reason, of course, is they know the strategy can produce consistent returns in a variety of market environments.

Writing "covered" calls has been a popular portfolio hedging technique almost since listed options were introduced to the equity markets. While it's impossible to know which method has enjoyed greater use, retail investors have traditionally focused on out-of-the-money (OTM) call options because they offer additional income as well as the possibility of capital gain. This approach is certainly viable in situations where the outlook for the underlying issue and/or the resultant cost basis of the position warrants additional risk, but it also has a lower probability of success. In addition, any upside potential is dependent on favorable stock movement thus the value of an out-of-the-money covered-call portfolio will be much more volatile on a relative basis.

A More Conservative Alternative

Some years ago, option guru Larry McMillan described a short-term, in-the-money (ITM) approach to covered-call writing. He called this strategy the "total return" concept because it wasn't predicated on forecasting a stock's directional movement but rather on identifying (long stock/short call) combinations that had a high probability of achieving a small gain. An investor who uses this conservative tactic considers the covered write as a single entity and is not interested so much in long-term stock ownership or bullish activity in the underlying issue, but in obtaining a consistent return on investment. When evaluating ITM covered-call candidates, the investor's primary objective is to identify stocks that will remain above the cost basis of combined position until the sold options expire. There is no concern about the stock's future potential; the focus is on the lowest possible price that will achieve a successful outcome. Since the sold call options are in-the-money, the maximum profit is established when the position is initiated and any additional gains in share value, beyond the strike price of the sold option, is meaningless. Of course, this fact does not imply that selling in-the-money calls is always a favorable technique. Quite the contrary, it is prudent to have (at a minimum) a neutral to slightly bullish outlook on the underlying issue, no matter how the covered-write strategy is applied.

At times, the process of comparing different time frames and strike prices for a covered-call position may seem overwhelming to less-experienced traders. However, the steps involved are much simpler when the yield is calculated based on the share value remaining unchanged. Using this method, there are no assumptions about future market trends and a more accurate (month-to-month) return can be determined. In his book, "Options As A Strategic Investment," Larry suggests looking for positions that offer a minimum profit of only 1%-2% per month with downside protection of at least 10%, and this ratio is generally available only through the sale of in-the-money call options. Obviously, these guidelines are very conservative hence more adept market participants often spread their holdings across a variety of ITM and OTM positions to balance portfolio risk with potential return on investment. In the end, determining the most appropriate option (strike) to sell in a covered-call position is simply a matter of identifying one's personal risk versus reward attitude.

Investors who have never sold in-the-money calls may be concerned about the possibility of an unexpected assignment but that's not a problem when stock ownership is secondary to achieving consistent profits. In fact, having the stock "called" early will actually increase the position's yield by providing the maximum possible gain in a shorter time frame. In those cases where an exit or adjustment is warranted prior to the expiration date, the sold (short) calls can always be repurchased, thus eliminating the need to retain the stock. An investor can also roll forward and/or down to longer-term options in order to lower his cost basis or attempt to rescue a losing position. Although the sale of (ITM) covered-calls is inherently a conservative strategy, an individual's success depends greatly on effective stock selection and the use of proven money-management techniques to limit losses when they occur. Technical analysis is commonly utilized to identify primary trends and areas of recent buying support, which can assist in establishing the correct entry and exit points. There are also various stop-loss methods an investor can employ in position management: a fixed percentage of one's overall portfolio value, a specific dollar amount, a violation of a technical trend-line, etc. It really doesn't matter whether the method of position management is mental or mechanical; the key to earning regular income is adhering to a system that will generate reasonable, consistent profits and minimize draw-downs from losing trades.

The proficient covered-call writer is always striving to find positions that offer a reasonable balance between profit potential and downside protection. In the Covered-Call System, we offer a wide range of candidates suitable for a variety of investors. However it is important to remember that all of the positions are provided simply to supplement the search for profitable opportunities. All forms of trading have risk, consequently it is imperative that each individual reader perform their own due diligence and, as with any investment, decide if the published selections meet his or her personal investment criteria and risk-reward outlook for favorable covered-call positions.

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