Option Investor

Covered-Calls 101

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When Should You Use Covered Calls?

There are a number of reasons an investor would use a covered-call to profit from the expected price activity of the underlying issue. A person might want to generate additional income on long-term portfolio holdings, boost the potential rate of return on speculative stock purchases or achieve small, consistent gains through the sale of "in-the-money" options. In many cases, the motivation for a stock owner to sell calls against shares held in brokerage account simply revolves around the desire to increase downside protection in exchange for limiting upside potential. Obviously, no investing technique is infallible however those who write covered-calls can enhance the likelihood of a successful outcome by initiating new positions during favorable market conditions.

In the covered-call strategy, the investor buys (unless he currently owns) a particular stock then sells a specific number of call options to hedge his long position; the ratio is generally one call option for every 100 shares of stock. Once the opening transaction is completed, the investor is obligated to deliver the stock at the strike price of the sold calls if/when the options are exercised by the buyer. In short, the stock owner is paid a fee or "premium" to agree to sell his holdings at a certain price (the strike price of the sold calls) and forego any additional gains in share value beyond that point.

Most stock buyers favor issues with strong bullish trends but they may not be aware of how the sale of an "in-the-money" covered-call can be used to increase the probability of achieving a (limited) profit in that situation. A good example of upside momentum can be found in Mindray Medical International (NYSE:MR) and on 12/3/06, it was one of the candidates offered to subscribers of the Covered-Call System. Mindray Medical is a developer of medical devices in China and similar to many new companies in that region, its stock price has soared during the three months since it was introduced on the NYSE. Our selection of MR was based primarily on the technical strength of the issue and considering the apparent lack of selling pressure, a cost basis near the 25-day moving average seemed reasonable.

This is the published position:

Long MR stock at $24.49
Short JAN-$22.50 Calls @ $3.10
Cost Basis = $21.39
Maximum Gain = $1.11 per share
Maximum ROI = 5.2%

And below is a price chart of the issue as of Friday, 12/1/06:

As you can see, MR's current trend is quite constructive and although we expect the upside activity to continue in the near term, our sole objective is for the stock price to finish the January options expiration period above $22.50. Regardless of how high the share value rises, our profit is limited to $1.11 per share (less commission costs) because that is the difference between our cost basis in the stock and the strike price of the sold calls. Although the sale of call options against the stock limits our upside potential, it also increases our downside protection (in the event of a decline in share value) by 12.6%.

Another favorable circumstance for selling covered-calls occurs when the underlying stock rallies sharply from a sustained lateral trend. This type of technical "break-out" typically signals a resolution to the existing indecision among investors and can lead to significantly higher share values. In addition, the top of the previous trading range provides a formidable level of support for any future consolidations. Consider this chart of Royal Gold (NASDAQ:RGLD), which shows the stock's price activity as of 12/1/06:

During the period from mid-October through November, a relatively stable trading range is established between $28.00 and $30.00. Then, on the last day of the month, a surge of buying pressure propels RGLD's share value up and out of the recent lateral pattern. The previous overhead supply becomes a base for the next uptrend and the lack of technical resistance helps the stock price move higher in subsequent sessions. Since this type of activity often provides a good opportunity to initiate a low risk covered-call, we offered the following position on 12/3/06 in the CCS portfolio:

Long RGLD stock at $32.42
Short JAN-$30.00 Calls @ $3.40
Cost Basis = $29.02
Maximum Gain = $0.98 per share
Maximum ROI = 3.4%

Once again, the maximum profit is attained as long as the price of RGLD is at or above the call option's strike price ($30.00) at expiration. In addition, there is no loss until the share value falls below the cost basis ($29.02) of the combined position. Through the sale of an in-the-money call, the investor acquires substantial downside protection (10.5% before loss occurs) from a decline in price of the underlying stock and ensures a high probability of achieving an acceptable return on investment. He also retains all the benefits of stock ownership, such as voting rights and the ability to receive dividends until that time at which the shares are assigned.

The covered-call is widely regarded as a conservative investment strategy because it decreases the risk of outright stock ownership. The technique generally works best with neutral to moderately bullish issues and the use of margin can increase the rate of return in successful positions. Although writing covered-calls is not suitable for everyone, it may be appropriate for investors who are willing to receive a small premium in return for agreeing to sell a particular stock at a specified price. Those who choose to employ the strategy will soon discover that when applied correctly, it can help their portfolio value grow consistently in all but the worst market environments.

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