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Covered-Calls 101

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Profiting In A Bearish Market

Most investors have enjoyed favorable portfolio gains during the recent bullish activity in equities and our covered-call portfolios have also benefited from rebounding share values. Unfortunately, the current recovery may be short-lived and the cyclical nature of stock prices is one of the primary reasons the covered-call strategy can be very effective over the long haul.

While it is fairly easy for the average person to pick "winners" in a flourishing economic environment, statistics suggest that relatively few participants are able to consistently forecast major market moves or predict the point at which a primary trend will reverse. Indeed, the directional approach to trading is very difficult and that's why many prudent investors focus on achieving small but consistent returns with strategies where a successful outcome does not require long-term stock ownership or bullish price activity. One of the most popular tactics in this category, which involves the sale of in-the-money calls against portfolio holdings, is not dependent on upward movement in the underlying issue and it also benefits from erosion in option values.

A Conservative Approach to Covered-Calls

The primary goal of investors who sell in-the-money covered calls is to generate acceptable profits while still receiving an above-average amount of downside protection for unexpected declines in the stock. Rather than trying to find the "break-outs," the trader who uses this approach is more interested in the overall technical outlook of the underlying issue for the duration of the option series chosen. He strives also identify situations where there is a high probability of the stock price remaining above the cost basis (break-even point) of the combined position until option expiration and there is a favorable risk versus reward ratio.

Regardless of the time-frame in which the in-the-money covered call strategy is applied, it requires a neutral to bullish outlook on the underlying issue and its sector industry or industry group. It is also important to consider upcoming events (earnings, FDA reviews, etc.) for the company and the trends of broader equity averages. If the overall market is due for a correction, or there is a potential catalyst for bearish activity (either of which could cause the stock price to fall below the cost basis of the position), then searching for a different candidate, or waiting for a more optimum entry point, may be the best course of action.

In those cases where the investor desires long-term stock ownership, entry timing is less critical but is still important to identify the key trends and trade appropriately. Essentially, an investor begins selling calls against the stocks in his portfolio as they cycle through the first three stages of price activity (basing, breakout/rally, consolidation) and with the use of advanced technical indicators such as oscillators or other timing signals, he can generally improve the profit potential of a covered call play. Once an issue moves into the fourth or "bearish" stage (which involves sustained distribution), the size of the holding is reduced to prevent capital losses.

Obviously, there are many ways to enhance the covered call strategy such as varying the option strikes and expiration dates, as well as using different types of position management. The resulting outcomes depend primarily on each individual's personal preference and the manner in which he of she chooses to initiate and terminate covered call trades. A range of tactics for this strategy are identified in "New Insights on Covered Call Writing: The Powerful Technique That Enhances Return and Lowers Risk in Stock Investing." The book, which is co-authored by option guru Larry McMillan, is available in the OIN bookstore or your local library.

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