Option Investor

No Bulls Roaming In This Market!

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As long as concerns about global recession continue to plague the equity markets, there will be very few opportunities for viable covered-call positions. With that dilemma in mind, we decided to forego the normal (weekly) search for a large group of possible trades and focus instead on teaching the average investor how to enter and exit a covered-call 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 few covered-call candidates identified in this week's preliminary scans for option premium: Emergent BioSolutions (NYSE:EBS). This is a SPECULATIVE position and suitable only for moderately aggressive investors. Although we do 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 EBS Stock: Last Price = $15.65
Sell NOV-12.50 Call (EBSKV): Bid Price = $3.90
Cost Basis = $15.65 - $3.90 = $11.75
Downside Protection = 24.9%
Maximum Profit = 6.38% (without margin)

Our initial net-debit target for the combined (EBS stock/NOV-$12.50 call option) position will be $11.65, which is slightly below the cost basis listed above. If this entry price is achieved, the maximum profit potential will be 7.29% and the downside break-even point will be 25.5% below the current cost of the stock.

Traders should research EBS thoroughly before initiating this trade. The process can begin with information from your personal brokers or via any of the major (online) financial websites. The objective is to ensure the stock meets your personal investing criteria with regard to fundamental value, technical outlook, share price volatility, etc. It is also critical to know and evaluate the potential affects of any recent and/or future events such as earnings dates and scheduled announcements.

Although we won't be making any actual trades, we will track the stock and option prices of EBS 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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