Option Investor

Covered-Calls 101

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Writing Covered-Calls: A Brief Tutorial for New Subscribers

Investors usually write covered-calls to generate monthly income, collecting money for the sale of an option against a stock position in his or her portfolio. This conservative strategy can be used effectively on all type of stocks as long as the outlook (fundamental and/or technical) for the issue is favorable.

For a novice trader, the primary advantage of a covered-call is the technique is easy to use and the resultant position is more conservative than outright stock ownership. In writing an option on the stock, the investor has partially insured the issue against a future drop in value. Of course, the downside risk in ownership is not eliminated, only reduced. In addition, the actual cost of opportunity loss or potential upside movement can be substantial thus the resultant risk-reward outlook is a "high probability of limited profit." A second benefit to this approach is it allows new investors to learn successful trend-trading techniques with a small margin of safety while managing the combined position for upside profit and downside risk. There are other, more subtle benefits and disadvantages but these are the most common reasons that investors choose (or avoid) this strategy.

How to Initiate a Covered-Call Position

There are two basic approaches to writing a Covered Call:

1) Sell call options against stock that is already owned.

2) Buy shares of a specific stock and simultaneously sell an equivalent number of call options against it. This strategy is often called a "buy write" and it has a number of advantages but most importantly, it guarantees the opening trade will be expected only when it meets specific criteria with regard to stock price and option premium.

Understanding the Buy-Write

When placing a buy-write order, you are requesting to purchase shares of stock and sell call options for a specific "net" price, with both transactions occurring at the same time. Since the cost basis is established prior to the trade, a buy-write order is the easiest way to initiate a new covered-call position. The exact phraseology (when speaking to an account representative) is not important but a "net-debit" must be given when the trade instructions are delivered to the agent. The floor broker or clearing-house will fill the order if the specified net-debit can be achieved through any combination of stock and call-option prices.

Using the Candidate Lists

1) Review the most recent listing on the Portfolios page of the Covered-Calls System at OptionInvestor.com. Here's the direct link to the current newsletter.

2) Choose a group of candidates (ITM or ATM/OTM) that meets your risk versus reward criteria. Some traders may want to focus on more aggressive, momentum-based plays while others will lean towards low risk, easy to manage positions. One you have selected a specific portfolio, review the individual positions offered and conduct some research on the underlying stocks to determine which issues meet your personal investment criteria (fundamental valuation, forecast earnings/profitability, technical character, etc). When you have identified a favorable stock/option combination, decide how many shares you want to purchase (usually a minimum of 500) and place an order with your broker using the "buy-write" technique. Traders who want to submit the order online will need to consult with their individual brokerages for instructions on using specific software platforms.

3) Once the order is in place, it will need to be monitored for execution. If a "fill" is not achieved in the first few days after the position is offered, it may no longer be available at recommended price. At that point, you can either adjust the net-debit to yield a smaller profit or forego the position entirely in favor of a new candidate. Only you can make this decision, based on your individual risk-reward outlook.

4) After the order is filled, the price activity of the underlying issue should be monitored on a daily basis. The objective is to detect any unwanted changes in the stock's technical character in a timely manner. If this occurs, it may be necessary to modify the position to limit the effects of adverse market activity. While a covered-call affords additional downside protection for the stock price, a large decline can rarely be tolerated without capital loss. Occasionally the issue will recover prior to the option expiration date, however the best course of action is to curb losses before they significantly affect portfolio value. In addition, some plays can be closed early for a small (but favorable) gain, thus releasing account funds for a new covered-call position.

Achieving Consistent Success

1) The most critical components of a successful covered-call portfolio are comprehensive research and effective money management. Once you have a candidate in mind, do your homework! Study the company and its calendar including upcoming events, earnings dates and any other scheduled reports. Prior to executing a transaction, know exactly what the break-even (cost basis) point is, and be prepared to take action if the underlying issue reaches that price range. After you take a position in a particular issue, stay informed by monitoring all the news and announcements affecting the parent company. Observe the daily progress of your stocks and realize that you have the ability and control to adjust or close the position at any time. Obviously you do not need to check the prices on an hourly basis, but we do recommend that you review each session's closing quotes. News and public opinion can have a significant impact on a stock's price and unfortunately, it is impossible to research "future" events before you buy an issue. The key to success is to be fully prepared for any occurrence so you can respond in a timely and effective manner.

2) Although the concepts of most exit and adjustment strategies are relatively simple, there is no such thing as "perfect" position management. With stock and option combinations, the best approach is to evaluate the risk-reward ratio of each possible scenario and implement the strategy that best fits your initial trading plan and (revised) technical outlook for the underlying issue. Success with covered-calls lies in one objective; a consistent flow of monthly income with limited portfolio risk. Any position that becomes unfavorable due to changes in the fundamental or technical characteristics of the underlying issue should be removed from the portfolio before it can generate significant deficits. Catastrophic failures are not unavoidable but they should be managed to reduce the effects of the shortfall. At the same time, there will be occasions when issues fail without warning, leaving no opportunity for exit or adjustment. In the stock market, unexpected events simply occur; earnings warnings, shareholder lawsuits, negative news in the industry or sector and changes in public sentiment. All of these activities can affect the success of an individual position but with a properly allocated and diversified portfolio, the long-term effects are minimal.

3) The most difficult lesson for a new trader occurs when it becomes necessary to close a losing trade. Indeed, it is very hard to learn to exit unsuccessful plays in a timely manner but the simple fact is, there is no reason to hang on to a losing position when there are so many other profitable plays that deserve your time and money. Accept your losses, learn from your mistakes (evaluate each one critically) and move on! Losses are inevitable with any investment strategy and instead of being surprised, you must anticipate them. History has proven that a percentage of the covered-write candidates will be unprofitable thus when the situation arises, it is not regarded as a failure but rather an integral part of the system. Further, your portfolio's performance should be evaluated based on the sum of its parts, rather than each individual trade. With this approach success is gauged by growth in account value and the losses become less significant. Indeed, that is one of the principal reasons for entering several positions; it is much easier to identify and act on a potentially negative play when it doesn't have a substantial effect on your overall success.

One last thought, Richard Lehman's book; New Insights on Covered Call Writing, does an excellent job explaining the various adjustment strategies used with covered-call positions. This title is currently available in the OptionInvestor.com bookstore and it is well worth reading, regardless of your experience level.

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