Option Investor

Covered-Calls 101

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Position Management

The recent bearish activity in the market has made stock ownership a difficult strategy at best and given the potential for further downside movement, it seems prudent to review some of the common exit and adjustment techniques for covered-call positions.

Writing covered-calls is one of the most conservative methods used to profit from stock ownership, however there is risk of loss in all forms of investing. In addition, every strategy requires a disciplined approach and sound money-management techniques in order to achieve profits on a consistent basis. Although selling covered-calls does hedge against a decline in the value of the underlying issue, the technique is not a remedy for protracted bearish activity; it simply offers a high probability of making a consistent (limited) return on investment.

When stock ownership is involved, many investors employ stop-loss strategies to limit losses during unfavorable market trends. Generally, some type of technical (sell) signal triggers the closing order, forcing a timely exit or adjustment. The trigger may be as simple as a percentage decline in share value or a move below the break-even point of the position. It may also be more complex such as countertrend reversals, oscillator crossovers, or any price activity that results in a violation of the stock's primary trend. Regardless of the manner in which the transaction is initiated, the objective is to rely on a mechanical signal rather than intuition or some other human impulse to close a losing trade. Of course, no form of position management is "perfect" nor will any technique protect against a catastrophic drop in the underlying, especially after the close (or before the open) of trading.

Once an investor decides to terminate a covered-call position, the process is simple. He can repurchase the calls (at the ask price) and sell the stock (at the bid price) or he may use a "net" order in the closing transaction to ensure an efficient exit trade. In that case, an order is placed with the broker to simultaneously sell the underlying shares and "buy to close" the sold calls for a specific credit - hopefully more than the current market price. For those who want to remain in particular issue, there are several viable alternatives such as rolling the calls forward and/or down or even using the "ratio-call" rescue strategy.

Generally, when an investor wants to be defensive and lower his cost basis in a covered-call position, he will roll the sold calls down and forward to a future expiration date. If this is done before the current (short) options expire, it is necessary to first buy back the sold calls, then he can write new, lower-strike calls in a distant expiration period. An investor who remains bullish in the long-term will do this to protect against short-term market weakness because ultimately, he expects the stock to recover. In some cases, he will have to move forward several months in order to obtain a credit in the new position. In rare instances, the best outcome that can be achieved is a small loss, which will at least be less than the current debit, providing the stock doesn't move significantly lower in the future.

Consider the recent position in American Airlines (NYSE:AMR). The issue was offered as a conservative covered-call candidate on May 5, when it closed near a multi-year high at $28.51. Here is the data for the original play:

Long AMR stock at $28.51
Short JUN-$25.00 Calls @ $4.30
Cost Basis = $24.21
Maximum ROI = 3.3%

Unfortunately, the stock began to trade lower almost the very next day and has since retreated to an intermediate (technical) support level at $25. Because a number of industry experts have a bullish outlook for the issue, some investors may want to hold the stock in expectation it will eventually recover from the current slump. If that's their intent, they might consider rolling down and forward to the NOV-$20.00 strike, which is selling for approximately $7.50. To make the transition, they must first repurchase the (short) JUN-$25.00 calls, which are trading near $2.00; then the NOV-$20.00 calls can be sold. The adjusted position offers a reduced cost basis of $18.71 ($24.21 + $2.00 - $7.50), which provides additional downside protection and offers a reasonable return on investment at the expense of tying up investment capital for an extended period. The specifics of the new position would be:

Long AMR stock at $28.51
Short NOV-$20.00 Calls @ $7.50
Cost Basis = $18.71
Maximum ROI = 6.9%

A less conservative move would involve the transition to AUG-$22.50 calls, which expire in roughly three months. Once again, repurchasing the (short) JUN-$25.00 calls increases the investor's basis in AMR to $26.21 per share. However, the subsequent sale of AUG-$22.50 calls should yield a premium of $4.90 per contract, thus lowering the break-even point to $21.31, less any commission costs. Here is the outcome:

Long AMR stock at $28.51
Short AUG-$22.50 Calls @ $4.90
Cost Basis = $21.31
Maximum ROI = 5.6%

Of course, these are only two of the many possible adjustments available and although one or the other alternative may work for certain people, each individual investor will need to find the position that best fits their personal risk-reward tolerance and outlook for the underlying issue. The essential concept to remember when you're in a covered-call position is there are different strategies that can be employed as time progresses. Despite what many people believe, an investor is not "locked-in" to the original trade. On the contrary, it is necessary to be flexible and creative with position management to ensure long-term profits with this approach.

In all cases, success with the covered-call strategy is based on effectively limiting the capital drawdown (and the potential for catastrophic portfolio damage) from a losing position. Stop-loss orders work well most of the time, but they are not appropriate for every unexpected decline in share value. Rolling the sold calls down and/or out to a distant expiration date can help offset the effects of short-term market downtrends, however the technique will not prevail in an extended bearish climate. The key to earning consistent income with covered-calls is to carefully evaluate the risk versus reward potential before entering a position then utilize proven money-management techniques in a timely manner, in order to maximize gains and minimize losses.

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