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Covered-Calls 101

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Another Strategy for Covered-Calls

With the major equity averages trading near historic highs, investors who sell covered-calls on long-term portfolio issues are looking for ways to limit potential losses from a market downturn. Some may choose to buy put options, thus creating a long position with unlimited upside potential and reduced downside risk (until the option expires). This is a conservative approach to stock ownership because it utilizes a unique form of insurance to guard against short-term declines in share value.

Investors who purchase protective puts should also consider another useful hedging technique that involves a combination of (short) call and (long) put options. The (bullish) Collar is a strategy which provides downside protection for stock holdings through the purchase of put options that are financed with the sale of call options. In short, an investor sacrifices upside potential for downside protection with fixed limits established for risk and reward. The name of the strategy stems from the "collared" profit-loss outlook, which is determined by the cost of the underlying asset and the respective strike prices of the long and short options, as well as the net debit (or credit) for the option portion of the position. By purchasing cheap put options and selling inflated call options, a collar often can be established for little or no out-of-pocket expense.

Here is an example using price data from a stock trading near $35.

XYZ STOCK PRICE = $35.05

SELL NOV-40.00 CALL BID = $2.05
BUY NOV-30.00 PUT ASK = $2.10

COST BASIS (LESS COMM.) = $35.10

MAXIMUM UPSIDE PROFIT = $4.90
MAXIMUM DOWNSIDE LOSS = $5.10

An investor purchasing 100 shares in this position would have to pay $3,505 (or $1,752 if stock was bought on margin). The price of the option portion of the transaction would be $5.00, due to the small debit for the put option. Of course, commissions can have a significant affect on the profit or loss in a combination position, so the exact prices should always be calculated prior to initiating any trade. With regard to the possible outcomes, a number of things could happen to the stock between now and the November options expiration:

1) The stock could remain between $30 and $40, which means both the call and the put would expire worthless and you would own 100 shares of XYZ at the current value, with no impact on the position from the options.

2) The stock could fall below $30 prior to the expiration of the put option, and in that case, your maximum loss would be $500, regardless of how much the share value declines. This is the advantage of the "insurance" portion of the collar because in a "stock only" position, the losses would continue to increase as the price of the issue declined.

3) The stock could continue to rally in the coming months, moving to $40 and beyond. If this occurred, you could adjust the position upwards (repurchase the sold call and sale a higher strike option) or you could allow the shares to be assigned at $40, which would yield a gain of $490 on $3,510 invested over a period of 6 months (28% annualized profit).

As you can see, the advantage of a collar when compared to simply buying a protective put is its lower cost. Recall that the premium received from the sale of the "covered" call is used to pay for the put. The shortcoming of a collar is the upside limit it places on the stock's profit potential. The sold (short) call establishes a maximum amount of profit that can be earned from an increase in the stock's price. For conservative investors, the put options act as a safety net in the portfolio, protecting its value against catastrophic declines in individual stocks. The sale of call options generates income to offset the cost of the protective puts, while at the same time sacrificing a portion of potential gains.

This strategy is best used when call option premiums are higher than the equivalent put option premiums. This type of price disparity is often referred to as a volatility "skew" and it tends to occur in active issues with upcoming events or announcements that have the potential to significantly affect share value. Earnings reports, FDA reviews and merger/acquisition-related activities are among the most common reasons for inflated options premiums and traders can exploit these opportunities by purchasing cheap puts and selling expensive calls. Depending on the situation, the collar can be a very attractive technique for conservative investors who want a favorable risk versus reward ratio with stock ownership in (potentially) volatile market environments.

Next week, we'll return to the fundamentals of covered-calls in the second installment of our new series for CCS readers.

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