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Covered-Calls 101

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Some Thoughts on Position Entry & Risk Versus Reward...

The first duty of every investor is to thoroughly examine any proven strategies that are appropriate for their individual experience level and risk-reward tolerance. Not surprisingly, many conservative market participants find that writing in-the-money covered-calls meets the basic criteria for a low risk, easy-to-manage investing technique. At the same time, stock buyers with a more aggressive outlook are often less successful with covered-call writing because the strategy has limited upside potential. There are never any large gains to offset the "big losers" thus they are forced to seek ways to increase the maximum return at the risk of increased downside exposure.

A frequent mistake among traders in this category involves "legging-in" to a covered-call. For those of you who are unfamiliar with this method, it entails trading the stock and option individually - trying to identify the lowest price at which to buy the stock and the highest price at which to sell the calls - in an attempt to improve the risk versus reward characteristics of the position. Of course, there are many problems with this approach. For example, what happens if the stock doesn't hit your buy target or worse, it does, but then continues to move lower? What happens if the stock price (after you have purchased it) remains relatively unchanged for an extended period of time, causing the option premium to erode before you sell the calls? What will your exposure be then? Does it outweigh your "potential" gain? As you can see, legging-in to a covered-call position can result in a higher yield but it also carries greater risk and the technique is often difficult to implement correctly, in a timely manner.

A better strategy to use is the "buy-write" order, which involves the simultaneous purchase of shares of stock and the sale of calls. When placing a buy-write order, you are simply requesting to purchase the underlying shares and sell the call options for a specific "net" debit, with both transactions occurring at exactly the same time. Since the cost basis is established prior to the trade, a buy-write order is a very effective method for initiating a new covered-call position. With the recent advances in software technology, most online brokerages now permit buy-write orders to be entered directly through their trading platform. For those who deal with a personal broker, the exact phraseology is not important however the specific stock and options, the number of shares/contracts, and a net-debit price must be provided before the request can be forwarded to an exchange. Once this information is received, the floor broker will execute the order if the requested net-debit (or better) can be achieved through any combination of stock and call-option prices.

The primary advantage of the buy-write is it prevents the possibility of "slippage" during the position entry process, when the premium in the call option declines. Slippage is generally described as the cost of buying at the ASK price and selling at the BID price but losses can also occur in the period between the stock purchase and the sale of the options in a covered-call position. This problem happens frequently with the candidates listed in the CCS Portfolios as many are opened in the first hour of trading on Monday, after the week-end edition of the newsletter is published. If too many calls are sold (by covered-call writers) without offsetting buying pressure, the bid prices drop quickly, often making a previously favorable position unviable. Traders who attempt to leg-in to these plays (buying the stock with plans to sell the calls later) are sometimes surprised to see the previously overvalued premiums disappear before they can write the options that complete the position.

With our in-the-money CCS Portfolio, we strive to minimize risk while obtaining consistent (low but acceptable) profits through stock ownership. For those who want greater gains, there are many methods available to enhance the potential returns that don't have the disadvantages of legging-in to the position. One alternative is the sale of partial positions using different strike prices and time frames. Another popular technique involves the systematic sale of options, where a trader writes covered-calls incrementally as the stock price rises. Of course, you can also look to the more aggressive portfolios, which focus on selling at-the-money or out-of-the-money options when technical indications suggest a predominantly bullish trend in the underlying issue.

As with any type of stock or options trading, the best approach is to tailor the strategy to fit your individual situation and implement it with discipline using proven entry, exit and adjustment techniques. Indeed, the key to success with most investments is effective money management; taking losses while they are small (in order to preserve portfolio capital) and closing some positions early for less profit, even as the little greed-gremlin is whispering "$$$" in your ear. We'll talk more about the methods commonly used to manage individual positions in an upcoming segment of Covered-Calls 101.

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