Option Investor

Covered-Calls 101

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A New Feature of the CCS

Today, we begin a new educational series designed to teach the average investor how to trade covered-calls effectively. For those readers who are new to this section of the Option Investor Newsletters, the Covered-Call System portfolios are published once each week and they include different categories (conservative/aggressive/longer-term) of covered-call candidates using the closing prices from the previous market session. The selection process for each portfolio is based primarily on the technical character of the underlying issue and the risk versus reward outlook for the combined stock/option position. Each category of covered-calls is listed in ascending order by percentage return however the relative ranking of a particular candidate does not necessarily reflect a higher probability of success or less potential for loss.

Since many readers use the popular "buy/write" technique to simultaneously purchase stock and sell calls, the current cost basis - per share of stock - is provided for each position. This price can be used as the net-debit in the buy/write order and it will generally be a good starting point during periods of average market volatility, where nominal changes in the stock and option prices occur after the opening bell. More adept traders may choose to place the initial order at net-debit which is less than the composite market price of the (long) stock and (short) option. Indeed, it is often possible to lower the basis of the position by $0.05 to $0.10 when opening a covered-call. The amount of reduction varies depending on the price of the stock and the option, the volatility of the stock, the amount of "premium" in the option, etc.

To illustrate the position entry process, we are going to use one of the candidates from the conservative CCS portfolio; Cal-Maine Foods (NASDAQ:CALM). Although we can not recommend a specific number of shares to purchase, a minimum amount (such as 300-500) is generally necessary to effectively offset commission costs.

The position specifics are as follows:

Buy CALM Stock: Last Price = $29.73
Sell MAR-25.00 Call (QKMCE): Bid Price = $5.30
Cost Basis = $29.73 - $5.30 = $24.43
Downside Protection = 17.8%
Maximum Profit = 2.3% (without margin)

Our net-debit target for CALM will be $24.30, which is slightly below the cost basis listed above. If this entry price is achieved, the maximum profit will be 2.88% and the downside break-even point will be 18.2% below the current cost of the stock.

Although we won't be making any actual trades, we will track the trading activity of CALM during the next few sessions to determine if the order could (likely) have been filled. Once this occurs, we'll move on to step two: managing the position.

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