Option Investor

Covered-Calls 101

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Covered-Calls for New Readers - Part II

In the first segment of this series, we discussed one of most effective tools for managing directional trades: the protective "stop-loss" order. Indeed, many investors use this technique in conjunction with stock holdings to limit losses during periods of unfavorable market activity. Normally, a long (stock) position is initiated and held until a specific, predetermined signal triggers the closing transaction. The signal may be as simple as a percentage decline in share value or it may be based on more complex "technical" indicators such as countertrend reversals, oscillator crossovers, or any pattern that suggests a change in the character (bullish/bearish) of the issue. These latter signals are derived from a study of the stock's chart or price history and although it is occasionally more art than science, we believe technical analysis is the best way to identify trends in financial issues. During the selection process for the CCS portfolios, we focus on the recent price action of stocks to help identify favorable buying opportunities. We also study the longer-term patterns to determine if the movement is likely to continue. In short, we believe the technical condition of a particular asset and its respective sector or industry group is the best indicator of future share values.

Technical analysis also lends itself favorably to portfolio management with covered-calls because after a position has been initiated, the performance of the underlying stock determines any forthcoming actions. If a covered-call writer is wrong in his assumptions about the future movement of the stock, he can simply close the position and look for another profitable play. In most cases, the outcome is a modest loss in capital and this (limited) shortfall is often more than offset by other gains in the portfolio. Of course, another objective of this approach is to prevent human emotion from dictating the exit point in a losing trade. Statistics suggest the primary reason novice investors achieve poor results with low risk/low return trading strategies is not due to a deficiency in play selection but rather because of their inability to effectively manage unproductive trades. While no form of position management is perfect (nor will any technique protect against a catastrophic drop in the underlying issue) it seems wise to utilize a mechanical signal, rather than intuition or an irrational impulse, to initiate the process.

If an investor wants to terminate a covered-call position prior to the (sold) option's expiration date, the procedure is relatively straightforward. He can simply repurchase the sold calls for the current ask price and sell the shares of stock at the bid price. He may also choose to utilize a "net" order in the closing transaction to ensure a more efficient exit trade. In that case, an order is placed with the broker to simultaneously sell the underlying shares and "buy to close" the sold calls for a specific credit - hopefully resulting in an improvement over the current market prices. In cases where the investor desires to retain the ownership of the underlying issue (with expectations of future upside activity), there are some viable alternatives. One of the most popular techniques is to adjust the risk versus reward outlook of the combined stock/option position by selling a new set of calls.

Generally, when an investor wants to be defensive and lower his cost basis in a covered-call position, he will "roll" the sold calls down and forward to a future expiration date. If this is done before the current (short) options expire, it is necessary to first buy back the sold calls, then write new, lower-strike calls in a distant expiration period. An investor who remains bullish in the long-term will do this to protect against short-term market weakness because ultimately, he expects the stock to recover. Depending on the situation, he may have to move forward several months in order to obtain a credit in the new position. In rare instances, the best outcome may be a small loss, which should at least be less than the current debit, providing the stock doesn't move significantly lower in the future.

Consider the recent position in American Airlines (NYSE:AMR), which was the subject of a comparable educational narrative a few months ago. Similar to the previous occasion, the issue was listed (on 10/22/06) as a conservative covered-call candidate.

Here is the chart and the data for the original play:

Long AMR stock at $27.70
Short NOV-$25.00 Calls @ $3.20
Cost Basis = $24.50
Maximum ROI = 2.0%

As with our earlier experience, AMR shares failed to breech a long-term resistance level (at $29) and have since drifted lower, settling near the bottom of a short-term trading range near $27. The chart below reflects the current consolidation, which could continue until the stock settles back into the previous lateral pattern (from $23-$25).

Because a number of industry experts continue to have a positive outlook for the legacy airlines and AMR in particular, some investors may want to hold the stock in expectation it will eventually resume a long-term bullish trend. If that's their intent, they might consider rolling down and forward to the JAN-$20.00 strike, which is selling for approximately $8.00. To make the transition, they must first repurchase the (short) NOV-$25.00 calls, which are trading near $2.80; then the JAN-$20.00 calls can be sold. The adjusted position offers a reduced cost basis of $19.30 ($24.50 + $2.80 - $8.00), which provides additional downside protection and offers a reasonable return on investment at the expense of tying up investment capital for an extended period. The specifics of the new position would be:

Long AMR stock at $27.30 ($27.70 - $0.40 credit from call repurchase)
Short JAN-$20.00 Calls @ $8.00
Cost Basis = $19.30
Maximum ROI = 3.6%

A less conservative move would involve the transition to DEC-$22.50 calls, which expire in roughly six weeks. Once again, repurchasing the (short) NOV-$25.00 calls increases the investor's adjusted basis in AMR to $27.30 per share. However, the subsequent sale of DEC-$22.50 calls should yield a premium of $5.40 per contract, thus lowering the break-even point to $21.90, less any commission costs. Here is the result of the transaction:

Long AMR stock at $27.30
Short DEC-$22.50 Calls @ $5.40
Cost Basis = $21.90
Maximum ROI = 2.7%

Of course, these are only two of the many possible adjustments available and although one or the other may work for certain people, each individual investor will need to find the position that best fits their personal risk-reward tolerance and outlook for the underlying issue. The essential concept to remember when you're in a covered-call position is there are different strategies that can be employed as time progresses. Despite what many people believe, an investor is not "locked-in" to the original trade. On the contrary, it is necessary to be flexible and creative with position management to ensure long-term profits with this approach.

In all cases, success with the covered-call strategy is based on effectively limiting the capital drawdown (and the potential for catastrophic portfolio damage) from losing positions. Stop-loss orders work well most of the time, but they are not appropriate for every unexpected decline in share value. Rolling the sold calls down and/or out to a distant expiration date can help offset the effects of short-term market declines, however even that technique will not prevail in an extended bearish climate. The key to earning consistent income with covered-calls is to carefully evaluate the risk versus reward potential before entering a position then utilize proven money-management techniques in a timely manner, in order to maximize gains and minimize losses.

Next week, we will look at another strategy for achieving consistent profits with covered-calls.

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