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Covered-Calls 101

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Here's some recent Q&A with current subscribers that might be helpful to new readers of the CCS newsletter...

QUESTION:

I just started using your covered-calls recommendations and I have some questions about a paper trade I made on OptionsXpress (OXPS). I bought 1000 shares of OXPS at $24.50 and sold 10 calls ($25.00) for the June 16 expiration. I received $500 for this sale. Now OXPS is at $27.00 so I can sell my 1000 shares with a profit of $2,500. That's very good but I don't know what I should do with the options. Should I buy them back before expiration? If I simply let them expire, then what will happen? If I buy them back, much of my profit will be gone. I know it would be the opposite situation if the shares went down in value; I could buy them back cheaper but the stock would be worth less too and there might not be enough profit from the options to cover the loss in the stock. I hope can you help me - it's important to understand this stuff before I try any trades with real money.

Regarding the mechanics of a covered-call...

Here is your scenario:

Buy 1000 shares OXPS stock at $24.50 per share = $24500 debit

Sell 10 JUN-$25.00 calls at $50.00 per contract = $500 credit

Net investment = $24000 ($24.00 per share)

If stock price is above $25.00 on June 16 (the expiration date), the calls you sold will be exercised by the person that bought them and he will get to buy your stock from you at $25.00 per share. In that case, you receive $25000; a gain/profit of $1000 -- and that's the most you can earn with the original covered-call position.

If the stock price is below $25.00 on June 16, you get to keep your shares because the calls you sold to someone will expire worthless. Then you can decide whether or not to sell your shares. If they are worth more than $24.00, you can make a small profit by selling the shares immediately. You may also decide to sell more calls for the July expiration, thus lowering your cost basis, or you may decide to just hold the stock and wait for it to go up in value.

If the stock is above $25.00 prior to the expiration date (June 16) and you decide to sell it, you will have to repurchase the calls to eliminate the obligation of providing the shares to someone else (when they are exercised).

Here is a link to a tutorial about covered-calls:

http://www.optioninvestor.com/premium/ccs/basics.aspx

Also, there is a book in the OptionInvestor bookstore that thoroughly explains the most popular options trading strategies:

Options as a Strategic Investment, by Lawrence McMillan

After you are comfortable with the strategy and the potential adjustments, you can look through the candidates offered in our newsletter to find positions that best meet your criteria for risk versus reward and fundamental/technical outlook. The key to success is earning consistent (small) profits and limiting losses. You must understand that covered-calls can help hedge the risk of stock ownership but the strategy will not prevent losses when the stock price declines substantially. Some hints: (1) Don't be greedy! If you are, this is not the right strategy to use. (2) Be sure to diversify your portfolio and never invest more than you can afford to lose. (3) Always monitor each position on a regular basis and utilize prudent money-management techniques to stop draw-downs before they become catastrophic.

Good Luck!

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QUESTION:

I subscribe to your covered calls weekly distribution. I have been using only ITM and have set up appropriate exit points and have been doing well. (3%/mo) My question is how did you do between 2000 and 2003 during the market decline? Did using ITM covered calls still work or did/do you recommend a different approach during these bear market cycles?

Thanks for your interest in the Option Investor Newsletters. All of us on the staff at OIN take great pride in providing the best stock and option research (as well as a large selection of analysis tools and trading resources) available on the Internet at a reasonable price. The various sections of each newsletter are designed to produce the best possible candidates in a variety of strategies so that you can focus on in-depth research and profitable trading, rather than searching through thousands of optionable stocks for a few viable positions. If that is the type of service you are interested in, the OIN offers one of the best values among online information providers for option trading.

Regarding your question about the success of "in-the-money" covered-calls in bearish markets: No strategy involving stock ownership is immune to losses when the primary trend is down. However, historical data suggests that conservative covered-calls typically provide higher average returns and lower standard deviation in a balanced portfolio. In addition, the strategy is even more productive during extended periods of lateral share value activity, when the only income generated by the stock comes from dividends. The key to success in this type of market environment is to spread your investing capital across a wide variety of industry groups, especially defensive and cyclical sectors and participate only in only those positions which meet your personal criteria for a favorable covered-call, based on the current (technical) trend, fundamental valuation, overall risk/reward outlook, etc. More information about covered-calls (including the results of some real-world profit/loss studies) can be found in the book: "New Insights on Covered Call Writing: The Powerful Technique That Enhances Return and Lowers Risk in Stock Investing" by Richard Lehman and Lawrence G. McMillan. The book is available in the OIN bookstore.

Good Luck!

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