Option Investor

Covered-Calls 101

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The "Best" Approach to Covered-Calls?

One of the most common questions we receive from new subscribers is "What is the best way to sell covered-calls?" Unfortunately, there is no correct answer to this question because there are many factors involved in determining an appropriate investing and/or options trading technique for a particular individual.

Considering the recent stock market volatility, those who desire less risk should probably utilize the in-the-money covered write as their primary strategy for achieving consistent (small) profits with stock ownership. This approach is often described as "aggressively conservative" and it is easy to master and also works in harmony with a low maintenance investing style. The opposite tactic involves writing out-of-the-money calls in conjunction with a "conservatively aggressive" outlook, where the underlying position is bullish and requires an upward movement from the stock for profit. Since the majority of covered-call writers are conservative, long-term investors with contempt for excessive risk and the potential for large losses, they generally favor the former method. In addition, history suggests the average investor will have greater success across a range of economic environments with in-the-money covered-calls as opposed to high risk, high reward (out-of-the-money) positions.

New option traders generally regard the in-the-money approach as too conservative to yield favorable returns but there is a reason for this attitude: they fail to grasp the power of compound interest. Covered-call writing allows investors to potentially compound their returns on stock ownership each month of the year. Unfortunately, while most investors begin using this strategy with the goal of growing their accounts slowly and steadily, many lose focus of the fundamental outlook of the technique (consistent, low risk profits) and start concentrating on higher, single transaction returns. This is a common mistake and it can substantially increase risk and the probability of loss. Statistics suggest the market regularly offers a 2-4% monthly (annualized) return for this conservative strategy but with diligent research and analysis, and proper money management, the amount of profit can be increased. In the Covered-Calls System Conservative Portfolio, we attempt to establish positions that offer, on average, a 2-4% (4-8% on margin) monthly return on investment. Even with this meager profit, the potential long-term portfolio growth is excellent due to the simple mathematics of compounding. Earning just 3% per month in an investment portfolio, without compounding or margin trading, equates to a 36% yearly return. Although that's much higher than CDs or saving accounts, most retail option traders regard a 3% monthly return as far too low. In fact, why would anyone want such a paltry reward when the market offers such great potential for wealth? There is answer is quite simple: RISK. Any strategy that yields 10% will be riskier (on a purely theoretical basis) than one offering a 3% return. Everyone knows the old adage, "The greater the risk, the greater the reward" but it's rare that an options trader can avoid learning this fact the hard way.

While it is not our preferred investment approach, there are a number of benefits and advantages to long-term stock ownership. If that is your intention, additional measures are necessary when utilizing in-the-money covered-calls. The most obvious problem involves the possibility of an (unwanted) exercise of the short position. As the options expiration date nears and the extrinsic (time) value or "premium" disappears from the sold option, you should consider rolling forward to reduce the likelihood of early assignment. The overall profit potential of the position will often increase and the outlook for the stock/option combination can be adjusted, consistent with your forecast for the movement of the underlying issue. With deep-in-the-money calls, most of the time value vanishes long before expiration however as long as some premium remains in the call option, there is little risk of early assignment. As the option's bid price moves closer to parity, there is an increased probability of exercise by arbitrageurs; floor traders who do not pay commissions for trading. When this situation occurs, you should consider rolling forward or adjusting the position in order to avoid a monetary loss through unexpected assignment of the short option.

The in-the-money covered call is a proven options trading strategy that can be used effectively with all type of stocks as long as the outlook (fundamental or technical) for the issue is favorable. For novice traders, the advantages of covered writing include ease of use and a favorable risk versus reward outlook (high probability of limited profit). In addition, the combined stock/option position is more conservative than outright stock ownership because through the sale of the option, the investor has partially insured the underlying issue against a future decline in value. Of course, the downside risk in ownership is never entirely eliminated and the potential opportunity loss from extreme upside movement can be substantial. While there are other, more subtle benefits and disadvantages to writing in-the-money covered calls, these are the most common reasons investors choose (or avoid) this strategy.

Good Luck!

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