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Covered-Calls 101

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Position Management Strategies for a Bearish Market

An investor generally writes (sells) calls against stock in his portfolio to receive income and/or limit the potentially negative effects of market volatility by reducing the overall cost basis in the issue. Unfortunately, the downside protection provided by a covered-call is not always sufficient to offset the capital losses endured in a significant market decline. In fact, this shortcoming can cause substantial draw-downs in some scenarios, thus it is vital to be familiar with the common adjustment techniques used in the covered-call strategy.

There are a number of alternatives when the value of the underlying stock falls below the sold (call) strike price in a covered-call position. The simplest follow-up action is to close the play and search for another, more profitable candidate. This exit strategy can be triggered by a percentage decline in the price of the underlying issue or it can be initiated when the stock falls below a pre-determined technical support level such as a moving average, trend-line, or trading range.

Another common technique used to avoid potential loss and reduce one's cost basis in the underlying issue involves "rolling" down (or down and forward) to a different strike price. To use this approach, the trader must repurchase the original calls (presumably for a gain, as the underlying stock has declined), and then sell new calls with a lower and/or more distant strike price. The idea is to create additional downside protection against a further retreat in the underlying issue and yet offer the potential for future income if the stock price stabilizes. The following example, which is based on a previous position in the CCS Portfolio, illustrates how a trader might respond to the recent bearish market activity:

In January of last year, Silver Standard Resources (NASDAQ:SSRI) was listed as a conservative covered-call candidate. The suggested position was:

Buy SSRI Stock for $ 16.36 per share
Sell FEB $15.00 Call for $1.80 per contract
Cost Basis = $14.56
Maximum Gain = 3%
Downside Protection = 11%

Everything progressed well until February 7, when the stock dropped $1.55 (8.77%) to $16.12 on weakness in the Precious Metals sector. At this point, the stock is below the recommended purchase price and the (short) FEB-$15.00 call option is trading for approximately $1.30. Since the outlook for this market segment remains bullish in the long-term, a roll-out adjustment may be appropriate. The most obvious transition involves a move to the same strike price, but in the coming (front) month:

Buy FEB $15.00 Call for $1.30 per contract
Sell MAR $15.00 Call for $1.80 per contract
Net Credit = $0.50 per contract
New Cost Basis = $14.06
Maximum Gain = 6.7%
Downside Protection = 12%

If obtaining extra downside protection is the more pressing concern, a trader could also roll to the next lower strike price in the coming month.

Buy FEB $15.00 Call for $1.30 per contract
Sell MAR $12.50 Call for $3.75 per contract
Net Credit = $2.45
New Cost Basis = $12.11
Maximum Gain = 3.2%
Downside Protection = 24%

Obviously, the process of rolling down can reduce (or eliminate) the profit potential of the initial covered-write. If a trader tried to move deeper in-the-money, say to the MAR-$10.00 strike, he would create a "locked-in" loss. Although it is not a pleasant experience, this type of adjustment may be necessary in certain circumstances in order to protect as much of the stock price decline as possible. Of course, the use of a distant expiration month can offset this effect and provide more time for this issue to recover from the bearish activity. Consider the sale of the JUN-$10.00 Call.

Buy FEB $15.00 Call for $1.30 per contract
Sell JUN $10.00 Call for $6.40 per contract
Net Credit = $5.10
New Cost Basis = $9.46
Maximum Gain = 5.7%
Downside Protection = 41%

The problem with using longer-term, deep-in-the-money calls is that a trader is risking his potential profit against an adverse market movement for an extended period of time. Again, this could be of secondary concern if the current trend of the underlying is suspect and downside protection is the primary objective.

One way to balance profit potential and downside protection involves dividing the original covered-call play into two new positions. By selling a combination of strike prices and/or expiration periods (such as rolling down one-half of the current position near-term and the other half longer-term), an investor can obtain maximum protection on a portion of his holdings and still retain reasonable upside potential for the overall position. We'll examine this method further in a coming narrative.

In most cases, using the roll-out technique is viable only when the trader has a long-term bullish outlook for the underlying issue. If bearish activity is expected in the near future, rolling out (or out and down) to the front-month calls will generally provide the best opportunity to capitalize on the available premium in the sold options, in the least amount of time. Although this process requires perseverance, an astute investor who "slowly but surely" reduces the overall cost basis in the position each month can usually achieve a profitable outcome in the end.

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