Option Investor

Covered-Calls 101

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A Guide for New Readers (Part I)

The Covered-Call System portfolios are published once each week and they include two categories (conservative/aggressive) of covered-call candidates using the closing prices from the previous market session. The selection process for each portfolio is based primarily on the technical character of the underlying issue and the risk versus reward outlook for the combined stock/option position. Each category of covered-calls is listed in ascending order by percentage return however the relative ranking of a particular candidate does not necessarily reflect a higher probability of success or less potential for loss. The key items in each listing are the stock to purchase and the option to sell (the option ticker, its strike price, and expiration month are included to ensure accuracy). Although we do not recommend a specific number of shares to purchase, a minimum amount (such as 300-500) is generally necessary to effectively offset commission costs.

Since many readers use the popular "buy/write" technique to simultaneously purchase stock and sell calls, the current cost basis - per share of stock - is provided for each position. This price can be used as the net-debit in the buy/write order and it will generally be a good starting point during periods of average market volatility, where nominal changes in the stock and option prices occur after the opening bell. More adept traders may choose to place the initial order at net-debit which is less than the composite market price of the (long) stock and (short) option. Indeed, it is often possible to lower the basis of the position by $0.05 to $0.10 when opening a covered-call. The amount of reduction varies depending on the price of the stock and the option, the volatility of the stock, the amount of "premium" in the option, etc.

As with most limited-profit strategies, the primary objective of the covered-call writer is to minimize losses and terminate unproductive trades before they become very costly, thus preserving account capital for future successes. Since we can not provide specific recommendations for closing or adjusting each individual play, it is incumbent upon the investor to develop a strict regimen for position management.

Those who are relatively new to stock and options trading should begin the process by considering their experience level and risk tolerance, and reviewing their financial resources to determine the maximum acceptable loss for any single holding. Once these personal criteria are quantified and a limit for draw-downs is established, it is much easier to choose the most appropriate strategy for limiting losses.

Although there are a variety of methods available in today's sophisticated markets, one of the most common position management techniques involves the use of a stop-loss order triggered by the price of the stock. The procedure is effective across a range of conditions because it is so simple: when the share value moves below a specific level, the stock is sold and the (short) call is repurchased thus closing both sides of the position. The principal advantage of this approach is the maximum amount of loss can be predetermined for all but the most volatile issues - those which endure a sudden, extreme price change. In addition, a "trailing" stop can be utilized to protect existing gains in situations where there is potential for a consolidation after the underlying asset has significantly increased in value.

Traders who plan to employ stop-loss orders should review recent (technical) support levels such as moving averages and trend-lines to determine the "trigger" point that will initiate the closing transaction. Keep in mind, the price at which the stop-loss order executes must be within the (previously established) maximum loss parameter for that particular trade. For example, an investor who initiates a covered-call with a cost basis of $9.50 and does not want to lose more than $200 (per contract/100 shares of stock) should ensure the stop-loss order is placed above $7.50. If there are no substantial technical support areas near this price, it may be necessary to raise the stop to an appropriate level or, in certain cases, to avoid the position altogether. An ideal situation is illustrated below in a recent CCS candidate; Illumina (ILMN).

As you can see, the cost basis ($29.66) in this conservative covered-call is below a well established support level, thus the placement of the stop is relatively easy (somewhere in the large range between the bottom of the current price channel and the point at which the trade begins to lose money).

In contrast, the placement of the stop in the example below is not as simple because the cost basis ($19.77) of the position is between two recent "top" formations. The previous top (near $20.50) may provide enough buying support to keep the share value above the strike price of the sold call. But, if the demand for (owning) the stock at that level is not sufficient, it may retreat to the area near the most recent top formation (approx. $19.00), which is well below the cost basis of the position.

Obviously, protective stop-loss orders are not perfect; they can be difficult to place effectively and there is risk of loss in volatile markets. At the same time, this technique is a powerful tool for managing losses and their use ensures that less experienced traders will focus on one of the most important elements of investing: establishing the exit points before entering a new position.

Next week, we'll review some common adjustment strategies for covered-calls on long-term portfolio stocks.

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