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Covered-Calls 101

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Looking For A Bottom...

Despite some of the optimism starting to emerge among technical traders, we have no tangible evidence the recent decline in equity values has come to an end. Although the past week's volatility may indicate the final stages of a sell-off, there is still potential for downside activity in stock prices and it's obvious the "R" word will continue to plague the economy (and investment portfolios) for many months to come. With that outlook in mind, our focus this week is on a small-cap company that should be relatively unaffected by broader market gyrations and may even benefit from rising energy costs. This company is Vaalco Energy (NYSE:EGY) and the position we have in mind is a longer-term, speculative covered-call.

Buy EGY Stock: Last Price = $5.03
Sell MAY-5.00 Call (EGY-EA) Bid Price = $0.45
Cost Basis = $5.03 - $0.45 = $4.58
Downside Protection = 8.9%
Maximum Profit = 9.2% (without margin)

The target entry price in this example trade will be:

Net Debit = $4.50
Downside Protection = 10.5%
Maximum Profit = 11.1% (without margin)

Since the movement of the underlying stock is related, in large part, to the cost of oil, this trade is only appropriate for those who have a bullish outlook for crude prices. We'll monitor the position in the coming week to determine if an entry is possible. A stop-loss transaction (or position adjustment) should be initiated if EGY's share price closes below $4.20 - $4.45, depending on each individual investor's risk versus reward tolerance.

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