Option Investor

Covered-Calls 101

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A Conservative Approach

In last week's segment, we discussed the sale of covered-calls on long-term equity holdings. While many of the comments and suggestions were relevant to our out-of-the-money candidates, most of the positions we offer are of a shorter duration and thus require a different approach. Today, we will present some suggestions on how to be successful with the conservative "in-the-money" plays listed in the CCS portfolio.

The primary goal of a covered-call writer is to generate income in conjunction with stock ownership. The ideal covered-call position offers both reduced risk and a high probability of earning an acceptable profit. Based on the recent rebound in shares values, our target return for in-the-money plays has increased slightly, averaging from 3%-4% for a four-week holding period. Regardless of which candidate you select for a covered-call, it is critical to open the combined position (long stock/short option) at the cost basis published in the newsletter. That's the only way you can expect to earn the percentage gain (return on investment) posted for each play. In addition, we suggest opening the positions with a "buy/write" or net-debit order. We don't recommend "legging-in" because in many instances, the option premium is gone (or greatly reduced) when the call option is eventually sold. Experienced traders may choose to buy the stock and sell the call later however that generally requires the stock to increase in value after it has been purchased; a very risky technique!

New readers may find the lengthy play lists somewhat daunting at first but the best way to profit from our research is to review the wide range of candidates and narrow them down through careful "due diligence" until you find plays that meet your individual risk versus reward tolerance. Once you have a few stocks in mind, take some time to examine each company's fundamentals and review the calendar for upcoming events (earnings/dividend dates, scheduled announcements, etc.). Keep in mind, when you have good knowledge of a stock and its industry, your potential for success is far greater than the average investor. A popular adage suggests that "knowledge is power!" and with the accessibility of research tools on the Internet, there is simply no excuse for being uninformed about a specific company or its industry group.

After a candidate has been selected, you must decide how many shares of stock to buy. The primary consideration in this process is capital allocation; employing available funds in a manner that yields favorable gains while keeping risk at a minimum. For the average investor, this means owning a sufficient number of stocks in a broad range of sectors so that an unexpected downturn in one issue or industry group will not substantially affect the portfolio's overall performance. While it may not always be practical, we suggest purchasing a minimum of 500 to 1000 shares in order to limit the effects (on return on investment) of transaction costs. In addition, we recommend the use of online discount brokers who specialize in retail option trading to further reduce commission fees. Of course, they may not offer individual investment advice or "personalized" services but many discount brokers outclass the traditional firms when it comes to order execution and web-based trading platforms.

After your order is filled, it is critical to stay informed by monitoring all the news and announcements affecting each stock until the sold call expires or the position is closed for other reasons. If all goes well, the issue will move as expected and the trade will result in a profit. Needless to say, there will also be times when it is necessary to exit a losing play and this can be a challenging ordeal when emotions enter the equation. Some people have trouble admitting failure (pride) while others convince themselves of an impending recovery (hope). In either case, the position management process is made more difficult and the draw-down is often exacerbated by refusing to take a loss when it is small. In truth, there is simply no reason to hold on to a losing trade when there are so many other profitable opportunities that deserve your time and money. Accept your losses, learn from your mistakes (and evaluate each one critically) then move on! Even in the worst-case scenario, you can use the experience to help develop proven money management techniques that will minimize the cost of losing positions in the future.

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