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Covered-Calls 101

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The recent market volatility has caused much anxiety among investors, even those who pursue a conservative approach to stock ownership through the sale of covered-calls. Despite the widespread concern, readers of this newsletter know how effective the covered-call strategy can be, especially during periods of lateral share-price activity. In addition, there are two principles that will help preserve the value of your stock portfolio when the long-term bullish trend comes to an end.

Diversity

All experienced market participants agree on the wisdom of diversification. In fact, most savvy investors understand that owning a diversified group of stocks, which perform well across a range of market conditions and economic cycles, is one of the fundamental prerequisites to long-term success. By spreading out across industries, the negative effects of violent swings in a particular stock or sector can be greatly reduced. For example, if one or two of the primary companies in a particular group move in a bearish manner, the rest of the stocks in that segment or business category are also likely to perform poorly. In contrast, when a well-known stock rallies, the odds are high that many of the issues in that sector will react in a comparable manner. This characteristic of the stock market is the main reason that traders with limited capital should divide their portfolio efficiently among a few positions in different sectors. When your capital assets are small, there is little margin for error, thus you should avoid "putting all your eggs in one basket."

Choosing issues in a variety of industries, as well as different growth categories, can help you take advantage of a wider range of trading opportunities during different market cycles. In the early stages of an economic recovery, small-cap firms typically offer the best growth opportunities because they generally have innovative products and services. At the same time, they may have higher share-price volatility and the associated liquidity risks because of their limited stature and relative instability. Later in the cycle, when growth begins to slow, many experts endorse "value" investing; owning under-priced stocks of established businesses that have a faster growth rate than large companies but with more stability than small companies. For those investors who want less volatility over the long run, a blue-chip portfolio may best as it focuses primarily on the stocks of large companies that, because of their asset base, tend to be the most stable. Another area of diversification includes the geographic component; buying stocks of companies located both in the United States and in other countries and regions around the globe. A favorable combination of all these groups would blend expanding companies priced below their long-term valuation with strong potential for above-average earnings growth in the future.

Some investors believe that diverse portfolios should contain a few issues which will react differently to changes in economic conditions, or the outlook for a specific sector or industry. These candidates are often identified as cyclical or secular stocks and one way to illustrate how they can be used to limit potential losses in a widespread market downturn involves stocks in the energy sector. A conservative investor might hedge his portfolio by initiating positions in both an electric utility and a major oil service company. Higher fuel costs will have negative impact on the utility, but will boost the value of the oil service issue. Obviously, the reverse is also true; lower oil prices will impact the oil service company negatively while improving the utility's outlook. This strategy protect can help protect your portfolio against unexpected downturns in a particular industry or market sector and also enable you to take greater risks with a few positions, which may increase overall profits.

Position Management

History suggests the most difficult task for the majority of investors is learning to properly manage losing positions. Indeed, timely and effective trade management is the key to success with strategies related to stock ownership and the approach you take will typically depend on your individual financial goals (consistent income, capital appreciation, speculative/momentum-based profits, etc.), your target time-frame (immediate, short-term, long-term, etc.) and your personal risk-reward objectives.

Although fundamental valuation can help determine the price of a stock over long periods, it is generally not precise enough to be used as a "sell" indicator during volatile market activity. With that fact in mind, professional traders often initiate an exit or adjustment order after a specific percentage decline in the value of the overall position or subsequent to a technical violation of a major support area (moving average, trend-line, etc.) in the underlying issue. Obviously, most stocks will falter in conjunction with a widespread sell-off however the best issues will retain their primary uptrend after the initial bearish activity has ended. Some questions that might help you determine the character or relative strength of a particular issue are: Is the stock still above its 30-, 50-, or 150-day moving average? Is the stock successfully testing (technical) support or has the support area failed? More importantly, does the stock have recent levels of buying interest or is it in a free fall with significant downside potential? Did negative news or company-specific events impact future earnings potential or significantly change the company's fundamentals, or was the drop in price simply due to selling pressure in the broader market? If the latter is true, what is the long-term technical outlook (overall trend and relationship to key moving averages, support/resistance areas, etc.) for the underlying sector/industry group and the major equity averages? Finally, how much impact will this trend likely have on your stock in the immediate future? Can you afford the interim decline in share value or do you need to cut your losses immediately and move on to a more profitable opportunity?

These are the types of questions an investor must answer before making an exit or adjustment trade with a covered-call position. Only after these issues are resolved can a person effectively evaluate the potential profit and loss for a specific situation and make a decision consistent with their risk tolerance and outlook for the underlying equity. In all cases, success with this strategy lies in one objective; a consistent flow of monthly income with limited portfolio risk. The focus of play selection and management should be to continually generate an acceptable level of option premium while protecting against the potential for downside losses. Positions that become unfavorable due to changes in the fundamental or technical characteristics of the underlying issue must be removed from the portfolio before they can generate significant deficits. Catastrophic failures are not unavoidable but they can often be managed to significantly reduce the effects of the shortfall. While each situation will require a different solution, in general you should try to limit individual position losses to no more than 15-20% of the initial investment amount. Unfortunately, there are occasions when issues fail without warning, leaving no opportunity for exit or adjustment. Unexpected events simply occur; earnings warnings, shareholder lawsuits, negative news in the industry or sector and changes in public sentiment. All of these activities can affect the success of an individual position but with a diversified, well-managed portfolio, the long-term effects will be minimal.

Good Luck!

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