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Covered-Calls 101

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FAQs about Covered-Calls

Many of our new readers have not had the opportunity to review all the past educational narratives so we thought it might be beneficial to cover some of the principal concepts of writing covered-calls in a Q&A format. This week's questions concern the sale of covered-calls against long-term portfolio issues.

Question: I have some blue-chip style stocks in my portfolio and I plan on keeping them for the long-term. I have started selling covered-calls to reduce my cost basis in each issue and I am looking for guidelines or suggestions as to how to make this strategy work best. Which options (OTM/ATM) should I be selling? How far out they should be? And, what criteria I should use to close an ITM option that might be exercised?

Answer: Selling covered calls is one of the most popular option strategies among conservative investors because income can be generated from portfolio holdings and this income helps reduce the risk of stock ownership. The amount of money produced by a covered-call depends on the relationship (distance) between the strike price of the sold calls and the current price of the underlying issue. While writing in-the-money covered-calls will yield the largest premium, the gain comes at a higher risk of being "called" (having to sell the stock prematurely) before the issue has reached its expected potential. When choosing which call to sell, most investors gravitate to at-the-money (or slightly out-of-the-money) strikes because they offer an equitable balance between upside potential and downside safety in the combined position. However, if the implied volatility in a particular series is extremely high, an investor may be able to move further out-of-the-money, using the inflated premium to establish an acceptable risk versus reward outlook. The key to choosing the correct strike to sell lies in a thorough comparison of the various series and their related premiums, which will reveal the best combination of risk (cost basis) and reward (profit potential) in the overall position. With regard to the appropriate time frame, it is unlikely an investor will be able to write front-month options on a consistent basis because option premiums on blue-chip (high quality) issues are generally less robust. On certain occasions (volume/price spikes, pre-earnings rallies, etc.), options prices may inflate slightly but in most cases, the stock owner will need to focus on selling calls in the second and third expiration months in order to receive an acceptable premium.

One of the principal concerns for an investor who sells covered-calls against long-term portfolio issues is the possibility of early exercise of the short options. In those instances where the value of the shares rises substantially after the calls are written, the easiest way to avoid assignment is to adjust the position by "rolling" the calls up to a higher strike price. When a position is rolled up - by repurchasing the current (sold) calls and selling higher strike calls - the profit potential is generally increased. The "catch" is that downside protection is surrendered. The new (downside) break-even point will be increased by the amount of money required to complete the roll-out transaction; the cost of closing the sold calls minus the credit received for selling the new calls. When using this technique, it is important to be sure that any debit incurred is worth the additional risk. One way to offset the cost of the position adjustment is to roll to a future expiration date in the sold option. Selling a longer-term call will increase the amount of money received, possibly even yielding a credit in the transaction.

As far as in-the-money options and the possibility of early assignment; there is little risk of this outcome as long as some amount of extrinsic value exists in the call option. Even if there is no demand for the option, a certain amount of time value will exist prior to expiration thus there is usually financial incentive for the owner of a call option to sell it for a premium (as compared to intrinsic value) rather than exercise it. Of course, there are situations where a dividend "capturing" opportunity may make the option a candidate for early exercise. This typically occurs when the dividend the buyer will receive (if the call is exercised) is greater than the interest expense incurred for carrying the underlying shares through the ex-dividend date. At the same time, if the option is in-the-money and the expiration date is near, it may be best to roll forward in order to reduce the likelihood of the options being exercised. An investor can simply repurchase the sold options and sell new, longer-term calls, either at the same strike price or in a different series; whatever is consistent with his or her outlook for the underlying issue. While statistics suggest the percentage of options exercised prior to expiration is very low, there is a much higher probability of arbitrage by institutional traders, floor brokers, etc., when the extrinsic value falls to zero; the option is bid at parity or less. The best way to prevent an unexpected assignment is to monitor the option's price whenever it moves in-the-money and if there is little or no extrinsic value, initiate the process of rolling the sold calls up, or up and forward, to prevent losing the stock and possibly, a future capital gain.

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