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Covered-Calls 101

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Position Management in Bullish Markets

A significant rise in share value is the ultimate goal of stock ownership but it is not always the best outcome when the stock is part of a covered-call trade. While bullish activity typically provides additional opportunities for profit, the risk of exercise of the sold (short) call increases as well. This condition poses no difficulty for short-term investors - other than dealing with the tax consequences of the stock sale - however those who want to hold on to their shares for longer periods must know how to adjust the combined stock-option position for maximum return while retaining an acceptable amount of downside protection.

If the value of the underlying issue (in a covered-call) increases substantially after the options are sold, the stock owner has several alternatives. He can choose to do nothing and, if the price of the stock is above the strike price of the sold calls at expiration, the options will be assigned thus providing the return that was established when the position was initiated. He can also repurchase the short options prior to expiration and sell the stock for a smaller overall gain. This action is generally best when the price of call is near parity because the closing debit is minimal and the reduced time-frame of the trade (and the resultant gain) helps outweigh the additional commission costs. Then again, if his primary concern is stock ownership, he can attempt to modify the position to match the revised outlook for the underlying issue. This is generally accomplished by "rolling" the sold calls up, or up and forward to a higher strike price. During this process, a new cost basis is established based on the realized credit (or debit) from the transaction.

For example, consider the most recent additions to our hypothetical portfolio: Canadian Solar (NASD:CSIQ) and Vaalco Energy (NYSE:EGY). An investor who initiated a covered-call trade in either of these issues would likely have experienced large (unrealized) gains in the underlying stocks. While these positions were intended to generate relatively limited profits using the covered-call strategy, one or both stocks may warrant continued ownership given their prevailing trends. If this is the desired outcome, the adjustment process is relatively simple; the investor repurchases the sold calls then writes longer-term calls with the same or different strike price, depending on the outlook for the underlying issue. If the expectated trend is bullish, the investor might roll up, selling new calls at a higher strike to increase the profit potential of the combined position. The drawback is that downside protection is reduced due to the debit incurred during the transaction. This means more money is being risked in a previously profitable position, so it is appropriate only in situations where there is a very high probability of additional bullish activity. A more defensive move would be to roll to the same strike or occasionally, down to a lower strike, in expectation of a lateral or declining share value. For conservative investors, this approach may offer the best balance between profit potential and downside protection but keep in mind, the strategy of writing covered-calls will only limit losses, not prevent them. If an investor becomes bearish on a particular issue, it may be wise to simply sell the stock and search for a completely new position.

Before making the final decision, it is important to evaluate the risk-reward outlook of each scenario and choose the alternative that best fits the investor's expectations for the future movement of the underlying issue. In addition, those who choose to initiate an exit or adjustment trade prior to expiration should consider using a "net" (debit or credit) order to ensure an effective transition to the new position. This involves repurchasing the sold calls and simultaneously selling the stock or new options and it can considerably reduce slippage; losses from multiple (untimely) trades that often occur when managing combination positions. Finally, it is important to be aware of the potential for early assignment when the existing calls are "in-the-money." This risk is most significant when the options are bid near parity (no extrinsic value) and with deep-in-the-money calls, the time value can disappear well before expiration. As long as there is some premium left in the calls, there is less risk of early assignment (and you can benefit from additional time-value decay by staying with the original position) but once the option trades near parity, there is a significant probability of exercise by arbitrageurs; floor traders who don't pay commissions.

During bullish market cycles, many investors utilize a momentum-based approach to trading covered-calls. The goal of this method is to identify trending stocks and write out-of-the-money options to provide a small margin of downside protection while allowing for additional capital gain. In those instances where the directional forecast is correct, it may be practical to exit a particular position early to "lock-in" the gains generated by the upward movement of the underlying issue. In other cases, stock ownership beyond the original (option) expiration date may be prudent when there is potential for future upside activity. The key point in both scenarios is that a trader does not have to wait for an in-the-money option to be assigned at expiration in order to take advantage of a profitable opportunity.

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