Option Investor

Covered-Calls 101

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This week, we continue our review of the covered-call strategy using a Q&A format.

Why is portfolio diversity so important and how can I accomplish this objective with covered-writes?

All experienced market participants agree on the wisdom of diversification. In fact, most savvy investors understand that owning a diversified group of stocks, which perform well across a range of market conditions and economic cycles, is one of the fundamental prerequisites to long-term success. By spreading out across industries, the negative effects of violent swings in a particular stock or sector can be greatly reduced. For example, if one or two of the primary companies in a particular group move in a bearish manner, the rest of the stocks in that segment or business category are also likely to perform poorly. In contrast, when a well-known stock rallies, the odds are high that many of the issues in that sector will react in a comparable manner. This characteristic of the stock market is the main reason that traders with limited capital should divide their portfolio efficiently among a few positions in different sectors. When your capital assets are small, there is little margin for error, thus you should avoid "putting all your eggs in one basket."

Choosing issues in a variety of industries, as well as different growth categories, can help you take advantage of a wider range of trading opportunities. In the current economic environment, many experts believe that small-cap firms offer the best growth opportunities because they generally have innovative products and services. At the same time, they may have higher share-price volatility and the associated liquidity risks because of their limited stature and relative instability. Those who endorse "value" investing would recommend owning under-priced stocks of established businesses that have a faster growth rate than large companies, but also more stability than small companies. A blue-chip portfolio would focus primarily on the stocks of large companies that, because of their asset base, tend to be the most stable. Another area of diversification includes the geographic component; buying stocks of companies located both in the United States and in other countries and regions around the globe. A favorable combination of these groups would blend expanding companies priced below their long-term valuation with strong potential for above-average earnings growth in the future.

Some investors believe that diverse portfolios should contain a few issues which will react differently to changes in economic conditions or the outlook for a specific sector or industry. These candidates are often identified as "hedge" positions and one way to illustrate the concept involves the oil sector. A conservative investor might hedge a portfolio by initiating positions in both an electric utility and a major oil service company. Higher fuel costs will have negative impact on the utility, but will boost the value of the oil service issue. Obviously, the reverse is also true; lower oil prices will impact the oil service company negatively while improving the utility's outlook. This strategy protect can help protect your portfolio against unexpected downturns in a particular industry and also enable you to take greater risks with a few positions, which may increase overall profits.

Position Diversification

With covered-calls, it's relatively easy to achieve diversity; simply sell options with different strike prices and/or time frames. The first technique is directly related to the risk versus reward outlook of the position. An aggressive approach using out-of-the-money calls offers higher overall returns but affords only a modest amount of downside protection. A conservative approach based on in-the-money calls provides greater downside protection but with a reduced profit potential. Some investors try to overcome this dilemma by writing out-of-the-money calls on some stocks and in-the-money calls on others. This tactic may work occasionally but it will rarely yield favorable results on a consistent basis. A better method for many covered-call writers may involve choosing a favorable issue and selling one half of the calls in-the-money and the other half of the calls at- or out-of-the-money. Through the use of different combination of options across diverse strike prices, the investor has additional opportunities to establish acceptable upside potential as well as adequate downside protection.

Stock owners with large positions in a specific issue can choose even greater diversification by spreading the sold calls over time as well as different strike prices. One can gain several benefits by writing a portion of the calls for a short period and the remaining calls further in the future. In the event of significant stock price activity, all of the various positions will not need to be adjusted at the same time. This may include having the stock called away or buying back some of the written calls and selling others. Another advantage is the level of option premiums may become more favorable than when the original series of calls were sold. At worst, only one group of options would be written when the premiums are low and hopefully, they would increase in value before the next expiration period. This type of diversification allows an investor to own various positions at different strike prices, smoothing the portfolio's balance as the market fluctuates cyclically. It also prevents all of one's stock from being committed at a single price, thus providing a favorable balance between potential return and downside protection.

Regardless of the manner in which you diversify your portfolio, it's important to understand that no strategy will prevent losses in every circumstance. In all cases, you should follow a precise and well-developed trading plan and be prepared to make timely, effective adjustments when unexpected events occur.

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