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Covered-Calls 101

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Risk Versus Reward & Return On Investment

Over the past few weeks, there have been some very profitable opportunities for investors. However, the market is not always so helpful when it comes to stock ownership and with this fact in mind, it is essential to know what level of success or, more importantly, what amount of profit, is typical when using the covered-call strategy. In order to answer these questions, it is first necessary to understand how return on investment (ROI) is determined with covered-calls.

The potential return on investment for a covered-call position is generally calculated with regard to two outcomes: return if called (RC) and return not called (RNC). Many traders focus on the RNC when evaluating similar covered-call candidates since there is no assumption made about the movement of the underlying equity. To compute this number, you simply take the net cash received from the sale of one call option and divide it by the cost basis of the position. The cost basis is the price per share of the underlying stock minus the cash received from the sale of one call option contract. (Note: This is also the minimum amount of equity, without using margin, required to initiate the position).

Return Not Called (RNC) Calculation:

Buy XYZ stock for $12.00 per share
Sell OCT-$12.50 call for $0.50 per contract
Cost Basis = $12.00 - $0.50 = $11.50
RNC = $0.50 / $11.50 = 4.3% (stock unchanged at $12.00)

For in-the-money (ITM) positions, determining the return called involves a similar process. The maximum profit is equal to the price of the sold option, minus the difference between the cost of the stock and the option strike price. As you would expect, the in-the-money RNC is the same as the RC, since the sold (call) strike is below the stock price. Regardless of the share value, this is the maximum return on investment.

In-The-Money, Return Called (RC) Calculation:

Buy XYZ stock for $12.00
Sell OCT-$10.00 call for $2.50 per contract
Cost Basis = $12.00 - $2.50 = $9.50
Max Profit = $2.50 - ($12.00 - $10.00) = $0.50
RC = $0.50 / $9.50 = 5.26% (stock unchanged at $12.00)
RNC = RC

For out-of-the-money (OTM) positions, the RC can be substantially higher than the RC, depending on the movement of the underlying issue. In this case, the maximum profit is equal to the price of the sold option plus the difference between the cost of the stock and the strike price. When the stock price increases, the RC moves up as well, until the sold (call) strike is in-the-money. In contrast, the RNC does not increase because it based solely on the cash received from the sale of the option (and assumes the stock price remains unchanged).

Out-Of-The-Money, Return Called (RC) Calculation:

Buy XYZ stock for $12.00
Sell OCT-$12.50 call for $1.00 per contract
Cost Basis = $12.00 - $1.00 = $11.00
Max Profit = $1.00 + ($12.50 - $12.00) = $1.50
RC = $1.50 / $11.00 = 13.64% (stock at or above $12.50)
RNC = $1.00 / $11.00 = 9.09% (no benefit from stock appreciation)

After the potential return on investment is ascertained, the procedure can be carried one step further to provide a better basis for comparison. This involves converting the gain or ROI to a monthly timeframe. Using the ITM-RC example above, a 5.26% profit earned in a 3-week (21 day) period could be characterized as follows:

ROI = 5.26 / 21 days X (365 days / 12 months) = 7.61% per month

Basically, the return is annualized and divided by twelve to produce a monthly basis. This computation helps investors visualize the value of compounding a seemingly small return over and over again. Of course, commission costs are not included in the ROI calculations as they vary depending on which brokerage and what level of service is provided. In addition, the purchase of common lot sizes such as 500 or 1000 shares will negate much of the impact of this expense.

Risk Versus Reward

With regard to expected returns, the simple truth is: positions that offer larger gains bear greater risk. Fortunately, the covered-call strategy can easily be tailored to any outlook from conservative to aggressive so the first step in position selection involves deciding which approach is most suitable for your particular situation. Once this task is accomplished, nearly every other decision is related to the ultimate objective; achieving (individually) acceptable gains on a diverse group of quality stock holdings while ensuring reasonable downside protection against unexpected market activity.

For our part in this process, we provide two categories of covered-call candidates: in-the-money (ITM) and at- or out-of-the-money (ATM/OTM). The primary goal of the more aggressive (ATM/OTM) portfolio is to profit from the capital appreciation of stocks in a bullish trend. The success of this approach is based almost entirely on the movement of the underlying issue, however the cash received from the sale of call options reduces the overall cost basis, thus improving the chances of a profitable outcome. During periods of favorable market activity, this tactic can yield gains in excess of outright stock/fund ownership, occasionally as high 8% - 10% per option expiration cycle. In the conservative (ITM) portfolio, the selection criteria are geared more towards the average investor; we seek to identify positions that, when initiated and managed with reasonable proficiency, have a high probability of yielding a modest, consistent stream of income. Using the latter methodology, it is reasonable to expect to achieve gains of 2% - 4% per month, when averaged on a yearly basis.

Although the covered-call strategy is often used in conjunction with long-term stock ownership, the typical investor will frequently achieve better results with positions where success isn't predicated on forecasting an issue's directional trend for extended periods. Remember, writing covered-calls will provide a small hedge against downside movement in the underlying asset but the technique is not a remedy for protracted bearish activity. In addition, the use of the strategy is always predicated on a neutral to slightly bullish outlook for the parent issue and its associated sector/industry group. Finally, success with covered-calls requires a disciplined approach and sound money-management techniques and, as with any investment recommendation, it remains your responsibility to employ "due diligence" and thoroughly research each issue you are interested in adding to your portfolio.

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