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Covered-Calls 101

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Simply A Great Strategy!

The strategy of writing covered-calls has long been referred to as one of the most conservative approaches to option trading available to retail players. For the average investor, selling "covered" call options offers a simple, proven method to generate cash flow on portfolio stocks in return for limited capital gain. However, there are other market participants (such as fund managers) who understand the risk versus reward characteristics of this technique can be much better than outright stock ownership or speculating in options. In fact, buying equities and writing calls against those (long) positions is a common tactic among institutional investors and it is also a well-known hedge strategy for professional traders that manage large stock portfolios.

There are a number of reasons why experienced investors utilize covered-calls to achieve above-average returns in their portfolios. One incentive is the flexibility offered by the wide variety of strike prices and expiration periods available with listed options. These components can be combined in different ways to create favorable profit-loss diagrams for virtually any market environment. A second motivating factor is the benefit of selling future potential in the form of option "premium," which reduces the risk of stock ownership and also takes advantage of the time-value erosion that occurs with each passing day. Of course, it's no secret that call options are generally overpriced in all but the most unfavorable economic cycles. Whether due to complex supply and demand issues or the widespread speculation that frequently occurs during an extended bullish trend, retail traders routinely pay more for call options than they are theoretically worth. This condition is simply another bonus for option writers because when options are expensive their premiums are larger and even a relatively small increase in the proceeds from covered-call sales can significantly boost the profits from this strategy.

The final catalyst for using the covered-call strategy stems from the regular distributions made to shareholders of publicly-owned corporations. In a covered-write position, the owner of the underlying stock retains any dividends issued before the option is exercised and the additional income can substantially improve a portfolio's annual returns. For this reason, hedge-fund managers typically sell options on companies that issue moderate to large dividends and retail players can benefit from the same approach. Obviously, there are some instances where the early exercise of options, known as "dividend capturing," will prevent an investor from receiving this added income but the effect can occasionally be offset by reinvesting the funds (from the sale of the stock) in another profitable position.

The methods fund managers utilize when implementing the covered-write strategy can be beneficial to the average investor as well. One of the most common traits involves the sale of short-term call options to obtain higher relative premiums in exchange for the limited capital gain. In most cases, the sale of longer-term options yields (proportionally) smaller returns when compared to writing a series of shorter-term positions. Another popular technique used by some fund and pension-plan traders entails buying high-quality stocks and selling in-the-money options for increased probability of assignment. When compared to outright stock ownership, this method is nearly equivalent to "pre-selling" the issue for a small profit. Some people may be surprised to know that institutions also use the popular buy-write technique when placing orders. Indeed, designating the net cost of the combined position when the order is placed eliminates price risk and affords the fund manager with an opportunity to negotiate a favorable basis in the underlying equity. An exchange specialist or floor trader will often agree to these terms in order to unload large amounts of the stock with only a small premium concession from the current market price.

As a rule, institutional traders utilize only the most successful strategies in order to guarantee a relatively consistent rate of return for their portfolios. Any method that produces less than favorable results will inevitably lower their supply of funds, thus it is quickly discarded in lieu of a more productive technique. The covered-write is commonly used by professional fund managers to generate modest, regular gains across a range of economic cycles while limiting the potential for large capital losses. Based on the historical success of this unique approach to stock ownership, it appears the covered-call may be the best way to outperform all but the most aggressive investing systems in the majority of market conditions.

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