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Covered-Calls 101

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Option Pricing & Risk Versus Reward

Option valuation is a complex and often misunderstood subject that usually requires a great deal of study to understand completely. Fortunately, the trader who perseveres will find there is a simple logic to most of the concepts. Those participants who become knowledgeable on the subject earn the right to have less money at risk and greater profit potential. And, as one becomes more familiar with the various components that determine an option's value, he is able to identify the most favorable positions on a regular basis.

The primary attraction of options is they provide the buyer with leverage; a person can realize a large percentage gain with only a modest change in the stock price. The concept of delta suggests that out-of-the-money options offer greater reward potential if the stock moves substantially while in-the-money options will perform better if the stock only moves moderately. Choosing the correct time frame of an option position also requires adept decision-making because the contracts closest to expiration are less expensive but generally require greater movement in the underlying issue to become profitable. While more time does cost more money, the easiest way to avoid time decay is to buy the most available.

Of course, it's not only option buyers that need to have a firm grasp of pricing theory to be successful - option sellers must comprehend the concepts as well. This fact can become painfully obvious when a trader initiates a short option position because of its robust premium without considering the possible consequences of the forthcoming volatility. As a general rule, the more expensive the option, the greater the potential for volatile price activity, thus the key to success lies in discerning which positions justify an inflated value. There are certain criteria to look for when analyzing volatility from a historical perspective and one of the best indicators is high implied volatility (IV) with regard to past levels. The circumstances improve when the current statistical volatility (SV) is also lower than the IV as this suggests the options have more premium than may be warranted by previous activity. Obviously, these are only broad guidelines and that's why volatility is one of the variables that must be clearly understood for a trader to achieve profits on a consistent basis.

After an options trader has become familiar with the basic tenets of pricing theory, the next important consideration is risk versus reward. In the derivatives market, buyers of options have limited risk and unlimited reward while sellers of options have limited reward and unlimited risk. With this single perspective in mind, it's obvious why the majority of retail traders simply "buy" options. Most investors would never consider a position with unlimited risk and yet few understand that almost any trade which isn't fully hedged entails enormous speculation. A violent, adverse move that does not allow time for adjustments can quickly reduce any position to a fraction of its initial value. With this fact in mind, it's hard to understand why traders would take outright long or short positions under any circumstances. The only possible explanation is they believe the probability of catastrophic loss is very small and the potential for profit is worth the risk.

Just as with life, the risks in option trading come in many forms. Fortunately, there are also many ways to trade and while risk versus reward is important, the probability of gain or loss is equally significant. When one evaluates a prospective position, the consequence of experiencing each possible outcome must be factored into the assessment. In short, is the reward, even a limited one, sufficient to offset the risk? Second, what is the likelihood of achieving the reward? One way to increase the probability of profit is to engage in some type of combination position, such as the covered-call. This is simply one way an investor can take advantage of inflated option premiums and also reduce the effects of short-term price fluctuations so that he can safely hold a directional trade to maturity. While there is no perfect strategy, successful traders learn to hedge their risk in as many different ways as possible, thereby minimizing the effects of adverse market movements. Although you may not be able to completely eliminate risk, you can reduce it much more than that of a novice player who does not utilize all of the available techniques.

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