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Covered-Calls 101

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Position Management Basics

As almost every trader knows, the key to success in the options market is position management. Regardless of how well you forecast the trend or character of a specific issue, you can still lose money if you don't understand how to maximize profits and minimize losses. However, that ability is one of the most difficult skills to master when dealing with limited-risk strategies because there is relatively little margin for error.

Due to the unique characteristics of derivatives, there are a number of techniques used to close, cover, and/or adjust common positions. But, there is more to position management than simply making a specific type of exit trade - timing is critical as well. Although the strategy of selling covered-calls is designed to reduce the risk of stock ownership, it also offers lower potential profits to offset the losing positions. This attribute suggests that a specific exit point is even more essential for those occasions when the trend of the underlying issue turns bearish because it is critical to keep the capital draw-downs to a minimum.

As the recent volatility in share values has demonstrated, knowing when and how to initiate a closing transaction is a requisite skill for any profitable trader. In addition, it is critical to avoid a reaction-based mentality when the market doesn't move as expected. Experienced players know that one of the easiest ways to prevent emotional decisions is through the use of a stop (loss) order. Stop orders are simply a method to follow the movement of a stock or other instrument while insuring some level of gain (or limited loss) if the primary trend changes character. There are two types of stop orders:

STOP ORDER

A stop order is an order to buy or sell an asset when the market for this asset reaches a specified price; the stop price. A stop order to buy becomes a market order when the asset trades or is bid at or above the stop price. A stop order to sell becomes a market order when the asset trades or is offered at or below the stop price.

STOP-LIMIT ORDER

A stop-limit order is an order to buy or sell an asset at a specified price or better, after a given stop price has been reached or exceeded. A stop-limit order to buy becomes a limit order when the asset trades or is bid at or above the stop-limit price. A stop-limit order to sell becomes a limit order when the asset trades or is offered at or below the stop-limit price. A stop-limit order is a combination of a stop order and a limit order. Stop-limit orders that have been triggered and converted into limit orders will execute if the asset is thereafter offered at or below the ask price for buy orders or at or above the bid price for sell orders.

In layman's terms: If you use a STOP order and the asset trades at or below your stop loss, the order will become a market order. This is not the case with a stop-limit order. If you use a stop-limit order and the issue moves too quickly to trade at the limit price, the order will not be executed.

With covered-calls, the maximum profit is predetermined thus the primary purpose of a stop order is to limit losses in the event of a significant decline in the underlying issue. The basic guidelines for establishing protective stops on the stock suggest that the initial or opening order should be placed at a point where important technical support is evident. Most often, this will be a relatively small range reflecting the bottom of a basing pattern or a specific point on a trend-line of the stock's price history. Some traders prefer to exit at the cost basis of the combined position or after a certain percentage (5%, 10%, etc.) decline in its value or their overall portfolio capital. In all cases, the primary objective of the stop order is to preserve one's assets if the price of the stock drops unexpectedly and yet, provide every opportunity for the position to achieve its maximum profit potential.

Obviously, some sell-offs may occur so quickly that the stop order will not be filled at the desired price. As with any trading strategy, unexpected volatility can be very difficult to overcome and it is further compounded by the improper type or placement of the stop order. An investor should always take into account the historical price activity of the issue when determining the initial exit point and in most situations a simple stop (not stop-limit) order is the best method to limit losses. Regardless of how well they are implemented, stop orders are not a "perfect" solution and generally will not protect against a catastrophic decline in the underlying issue, especially after the close (and before the open) of trading.

While these basic principles work well in the majority of circumstances, there will always be those instances when even the most common rules do not seem to apply. In particularly fast-moving markets where straight line advances make the placement of protective stops difficult, an arbitrary buy or sell "at the market" might be more advisable. There are also progressive stop order systems for traders who wish to fine tune the trend-following process to allow for brief periods of technical consolidation. Although stop orders can be used in many different ways, there is one fundamental principle that remains inviolate: protective stops under long positions should rarely be moved down, nor should protective stops over short issues be adjusted higher.

Keep in mind, success with covered-calls is based, in large part, on effectively limiting capital draw-downs (and the potential for catastrophic losses) when the stock doesn't move as expected. Stop (loss) orders typically perform well in this regard but they work even better when utilized in conjunction with other proven, risk-management techniques in a diverse portfolio of carefully selected positions.

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