Option Investor

Covered-Calls 101

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FAQs about Covered-Calls

In this week's narrative, we return to the Q&A format to explain some of the fundamentals of the covered-call strategy. Our discussion will focus primarily on the position selection process.

Question: How do you pick the Covered Call System candidates? Also, the basis for selling out-of-the-money calls is commonly known but what is the reason for writing (conservative) in-the-money options?

With regard to position selection, the research staff at CCS uses a relatively simple approach to identify a variety of covered-call plays in a range of industry groups. The process begins with proprietary computer software that creates lists of viable combinations based on analysis of stock charts and option pricing. The most favorable positions are then ranked by technical strength and profit/loss potential. Our recommendations are based primarily on historical prices and their indications with regard to directional trends, moving averages, and support/resistance levels. Trading volume and momentum indicators are also significant considerations in our initial screening procedure. All of these components are invaluable in the stock selection process and although we understand the need for fundamental valuation, we believe it is more important to focus on the current technical character of the broader market, its major industry groups, and individual issues.

Of course, there are many people who favor fundamental analysis when evaluating potential investments and it is always prudent to review the financial condition of a company when considering a stock purchase. However, there are certain situations better suited to one type of analysis and this fact is evident when you consider the different ways an individual might approach the covered-write strategy. For example, a conservative investor who utilizes trend and/or sentiment indicators would likely sell short-term, in-the-money options on technically favorable companies to achieve small gains. In contrast, an investor that focuses on fundamental or "valuation" analysis to make portfolio decisions would likely buy shares of historically profitable companies and write out-of-the-money options (with at least two or three months of time value) to reduce the overall cost basis of his position. Since the majority of candidates offered in the CCS are of a short-term nature, we simply prefer technical analysis as the primary means for stock selection.

As far as risk versus reward, the strategy we utilize to choose conservative covered-call candidates is based on the Total Return Concept described by Lawrence McMillan in his original book, "Options: As a Strategic Investment." With this approach, an investor considers the covered write as a single entity and is not interested so much in stock ownership or bullish movement but rather in obtaining a consistent (monthly) return on investment. In short, there is no long-term stock ownership intended with these (in-the-money) covered-calls; we expect (and desire) the shares to be "called" each month.

Obviously, forecasting stock price activity is a difficult science so in the "conservative" portfolio we attempt to identify positions that have a reasonable expectation for success in the short-term. Keep in mind, it is never wise to buy a stock you don't want to own at the end of the options expiration period (as that is always a possibility) and each investor has a responsibility to perform due diligence and thoroughly research any prospective issues. In many cases, the over-valued option prices that make the position possible are the result of expected volatility (the likelihood of an explosive move; up or down) from upcoming events such as earnings reports, potential mergers, clinical trial results, etc. A significant change in the stock price often occurs after an important announcement and this can be very detrimental to the covered-call writer. The volatile activity may result in unrealized capital gains in a rising market or excessive share value losses in a falling market.

The best condition for an in-the-money covered-write is a relatively stable market with a slightly bullish trend. If the price of the underlying issue moves laterally or even declines slightly, the stock will be called away thus yielding the projected return on investment. From a practical standpoint, the strategy is relatively easy to use with less risk than outright stock ownership but with limited reward potential. Of course, no technique is infallible - there is risk of loss in all forms of investing - so it is necessary to implement the strategy correctly (effective play selection and entry trades) and employ financial discipline (position management) in order to be successful in the long run.

The book "New Insights on Covered Call Writing," by Richard Lehman and Larry McMillan, is an excellent resource covering all aspects of the covered-write and it is available in the OI bookstore. For investors who prefer stock ownership, the book also describes various methods for selling calls on long-term portfolio holdings and some common position adjustment strategies. Regardless of which approach you favor, please become completely familiar with any method you intend to use before investing "hard-earned" cash - the market can be a costly place to learn.

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