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Covered-Calls 101

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Improve Trading Skills With Covered Calls

One of the primary advantages to covered-call writing is that it allows less experienced investors to improve their trend-trading skills while maintaining an additional margin of safety. The combined stock/option position provides reasonable profit potential and yet reduces the amount of capital at risk from unexpected market activity.

Investors typically write covered calls to generate monthly income, collecting a small premium payment in return for the obligation to sell a particular stock held in his or her portfolio. This conservative strategy can be used effectively on a variety of asset types, as long as the fundamental and/or technical outlook for the issue is relatively favorable. The main attraction of the covered call is an improved probability of limited profit and the technique is ideally suited to the novice trader because it is easy to master with a resultant position that is more conservative than outright stock ownership. In writing an option on the stock, the investor has insured the issue against a future drop in value. Keep in mind, however, the downside risk in ownership is not eliminated, only reduced. In addition, the actual cost of lost opportunity or potential upside movement can be substantial. There are other, more subtle benefits and disadvantages but these are the most common reasons that investors choose (or avoid) the strategy.

While there are a number of ways to profit from stock ownership, many people focus on the "in-the-money" covered write as their core technique to achieve consistent gains. This unique combination of (long) stock and (short) options is simple to implement and works in harmony with a low maintenance, low risk investing style. The guiding principle for the in-the-money approach is to be "aggressively conservative." This tactic is in direct contrast to the popular "conservatively aggressive" outlook used by many traders, where the underlying position is moderately bullish (due to the sale of out-of-the-money calls) and typically requires an upward movement from the stock to guarantee a profit. Although the latter practice can be very productive in certain market cycles, the majority of conservative, long-term investors have contempt for excessive risk and the possibility of large losses. Fortunately, studies suggest (and our past results confirm) that the average investor can achieve favorable annual returns with the consistently smaller losses through the use of in-the-money covered calls.

Some people may think this method is far too conservative to yield acceptable gains, however the "magic" ingredient of the strategy is the power of compound interest. Writing covered calls allows investors to potentially compound their returns on stock ownership each month of the year. Regrettably, most investors begin writing calls with the goal of compounding their money on a regular basis but lose focus of the fundamental benefit of the technique (consistent, low risk profits) and start to concentrate on higher, single transaction returns. This is a common mistake and it can substantially increase risk and the probability of loss. Historically, the stock market offers a 2-4% monthly return for this conservative strategy and with diligent research and analysis, and proper money management, the margin of profit can often be improved. However, those who achieve even the most meager gains can also enjoy long-term portfolio growth, based on the simple mathematics of compounding. Earning just 3% per month in a personal portfolio, without compounding (or margin), equates to a 36% yearly return. Obviously, most retail option traders would regard a 3% monthly gain as far too low. In fact, why would anyone want such a paltry reward when the market offers such great potential for wealth? The answer is quite simple: RISK! Any strategy that yields 10% will be much riskier (on a theoretical basis) than one offering a 3% return. You've heard the old adage, "The greater the risk, the greater the reward" and it's absolutely true. Sadly, many investors discover this reality "the hard way" before making the transition to in-the-money covered calls.

Regardless of how you approach the covered call strategy, it is generally wise to lock-in profits whenever possible and strive to keep potential losses to a minimum. A rise in share value is the ultimate goal of stock ownership and although upside potential is limited when calls are sold, a strong market rally can provide additional opportunities for profit. When the price of the underlying issue moves substantially higher after the initial position has been established, you have several choices. The first alternative is to do nothing, get "called-out" and accept the original return that was established when the play was opened. Second, if the option is priced near parity, you might choose to close the position early. Finally, you may also decide to adjust the position to match the current outlook for the underlying issue by "rolling" the call up and forward to a higher strike price. When you roll up (repurchase the current sold call and sell a higher strike call), the profit potential of the position is increased. Unfortunately, the cost basis or break-even point in the stock is also increased by the amount of additional debit required to complete the transaction. This is the primary reason many traders transition to a future expiration date when rolling up; it reduces or eliminates the cash outlay required for the new position.

When defensive adjustments are necessary due to a bearish market trend, the most common technique entails lowering the cost basis in the overall position. A person who remains bullish on a particular asset in the long-term will do this in order to protect for short-term weakness because the stock is expected to eventually recover. As a rule, the break-even price is reduced by rolling down and/or forward to a future expiration date. If the trade is initiated before the option expiration date, you must first buy back the current sold calls (which should be relatively cheap). Then you can look for new calls to sell, which will provide income to offset the decline in share value. Keep in mind, you may have to move forward several months, or possibly use LEAPs, in order to achieve a credit in the transaction. In all cases, you will need to evaluate the risk-reward scenario of each option strike and timeframe and select a combination that best fits your (revised) outlook for the underlying issue.

Those who are interested in more information should consider reading market guru Larry McMillan's book, "Options: As a Strategic Investment." It is an excellent resource for both stock and option traders and in chapter 2, he reviews the various approaches to writing covered-calls as well as some common adjustment techniques. The book is available in the OI bookstore.

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