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Covered-Calls 101

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KGC Hedge Position Closed

The recent decline in gold prices has taken its toll on gold-related stocks and the bullish covered-call in Kinross Gold (NYSE:KGC) was one of the victims. The original position had a cost basis near $21.85 and a stop-loss price between $23.25 and $24.00, depending on each individual investor's risk versus reward tolerance. Although Tuesday afternoon's sharp sell-off did not physically reach the trigger point, Wednesday morning's drop left no doubt that it was time to exit the play. Regardless of when and/or at what price ($23.25-$24.00) the stock was sold and the call(s) repurchased, the closing credit was substantially less the opening debit, thus creating a loss in the play.

Some readers might wonder why we did not advocate rolling this position to longer-term, lower strike calls. There are two primary reasons: (1) it was intended as a short-term portfolio hedge against further downside activity in the broader market sectors and (2), the technical character of the issue and its industry group; Gold Producers, changed significantly (for the worse) during the recent plunge in gold prices.

As adept investors, one of our critical tasks is to review our portfolio on a regular basis to identify unwanted changes (such as technical weakness) in the outlook for its holdings. When this occurs, it is generally necessary to exit or modify the affected position to limit the effects of adverse market activity. While a covered-call affords additional downside protection for the stock price, a large decline can rarely be tolerated without capital loss. Occasionally the issue will recover prior to the option expiration date however the best course of action is to curb losses before they significantly affect portfolio value.

With Calgon Carbon (NYSE:CCC) and Premiere Global Services (NYSE:PGI), the favorable fundamentals and well-defined technical support evident in both issues suggested a defensive "adjustment" was more appropriate, thus we initiated a process to lower the respective cost basis in each position. Recall that an investor who remains bullish on a particular asset in the long-term will do this in order to protect for short-term weakness because the stock is expected to eventually recover. As a rule, the break-even price is reduced by rolling down and/or forward to a future expiration date. Keep in mind, if the trade is initiated before the option expiration date, you must first buy back the current sold calls (which should be relatively cheap). Then you can look for new calls to sell, which will provide income to offset the near-term decline in share value. You may have to move forward several months (or use LEAPs) in order to achieve a credit in the transaction. In all cases, you must evaluate the risk-reward scenario of each option strike and time frame and select a combination that best fits your (revised) outlook for the underlying issue.

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