Option Investor

Covered-Calls 101

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Covered-Calls 101

In this week's narrative, we return to the Q&A format to discuss the covered-call strategy.

What type of position management works best with covered-calls and when should I close a losing position?

Although the basic aspects of most exit and adjustment strategies are relatively similar, no single method of position management will be effective in all situations. With stock and option combinations, the best approach is to evaluate the risk-reward outlook of each possible scenario and use proven techniques that fit your personal trading plan and technical outlook for the underlying issue. Keep in mind, success with the covered-call strategy lies in one objective; a consistent flow of monthly income and limited portfolio risk. The focus of position selection and management should be to continually generate an acceptable level of profit while protecting against excessive downside losses. In short, positions that become unfavorable due to changes in the fundamental or technical characteristics of the underlying issue must be removed from the portfolio before they can generate large deficits.

The type of position management you should use depends primarily on your objectives. Do you favor consistent income through the sale of options (and occasionally, from stock dividends) or do you strive for moderate capital gains from momentum-based positions. Are short-term trades preferable to long-term investments? Is your risk-reward tolerance conservative, more aggressive, or speculative? All of these factors contribute to the stock/option selection process and help determine the best strategies for managing each position. For example, a conservative investor might opt to sell at-the-money calls on high quality issues with little downside potential. His approach to position management would likely be far less stringent than that of a short-term trader who writes out-of-the-money options on volatile issues in extremely bullish trends.

With regard to exit and adjustment techniques, professional traders typically take action when the amount of loss reaches a percentage of the position's initial value or their overall portfolio value, or a fixed dollar amount. They may also close or adjust a position when there is a technical violation (by the stock) of a key support area such as a moving average, trend-line, etc. Many of the stocks identified in the CCS portfolios will climb fast and then falter, however their technical character will remain favorable. Other issues may simply drift lower until they encounter a long-term trading range and unfortunately, a few selections will transition to a sustained bearish trend. The latter group is most harmful from a financial standpoint thus it is best to identify these stocks as soon as possible. Some questions that may help with this procedure are:

1) Is the stock's price still above a 30-, 50-, or 150-day moving average? These are some of the common levels used by technicals-based traders and they are often viewed as "key" turning points for trend reversals.

2) Is the stock simply testing a technical support level (with selling pressure abating) or has the support level failed to halt the downward momentum with no further opposition to a future decline? Also consider the amount of trading activity as the stock price nears, or moves through, a crucial price range; increased volume, or an obvious lack of buying interest, suggests the current trend will continue.

3) Did an unexpected event or negative announcement impact the company's earnings forecast or significantly alter its fundamental value? Also, is this a long-term change in character or simply an overreaction to a relatively insignificant occurrence?

4) What is the primary trend of the underlying sector/industry group and the major equity averages? How will this trend impact the stock in the near-term and the distant future?

These are the types of questions an investor must answer before making an exit or adjustment trade with a covered-call. Although each individual situation will require a slightly different solution, a popular rule of thumb is to limit individual position draw-downs to no more than 10% of portfolio value. At the same time, there will certainly be occasions when an issue plunges without warning, leaving no opportunity to close the play without a large loss. Unexpected events simply happen; earnings warnings, shareholder lawsuits, negative news in the industry or sector, and changes in public sentiment. All of these occurrences can affect the success of an individual position but with a well-diversified portfolio, the long-term consequences are minimal.

Experienced market participants understand that losses are inevitable with any strategy so instead of being surprised, they anticipate them. Statistics dictate that a percentage of the positions you select will be unprofitable thus when the situation arises, it should not be regarded as a failure but rather an integral part of the investing/trading process. Your portfolio should be evaluated based on the sum of its positions, rather than each specific transaction. In this manner, success is gauged by growth in overall account value and individual losses become less significant. Regardless of which techniques you favor, effective position management can be very difficult in certain market environments. Maintaining a balanced portfolio with several diverse positions can make the entire process much easier and it also has another, more obscure benefit; human emotions are less likely to diminish your ability to identify and act on a potentially negative trade when it doesn't have a substantial effect on your overall success.

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