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Covered-Calls 101

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Position Management with Covered-Calls

As with most limited-profit strategies, the primary objective of the covered-call writer is to minimize losses and terminate unproductive trades before they become very costly, thus preserving account capital for future successes. Since we can not provide specific recommendations for closing or adjusting each individual play, it is incumbent upon the investor to develop a strict regimen for position management.

Those who are relatively new to stock and options trading should begin the process by considering their experience level and risk tolerance, and reviewing their financial resources to determine the maximum acceptable loss for any single holding. Once these personal criteria are quantified and a limit for draw-downs is established, it is much easier to choose the most appropriate strategy for limiting losses.

Although there are a variety of methods available in today's sophisticated markets, one of the most common position management techniques involves the use of a stop-loss order triggered by the price of the stock. The procedure is effective across a range of conditions because it is so simple: when the share value moves below a specific level, the stock is sold and the (short) call is repurchased thus closing both sides of the position. The principal advantage of this approach is the maximum amount of loss can be predetermined for all but the most volatile issues - those which endure a sudden, extreme price change. In addition, a "trailing" stop can be utilized to protect existing gains in situations where there is potential for a consolidation after the underlying asset has significantly increased in value.

Traders who plan to employ stop-loss orders should review recent (technical) support levels such as moving averages and trend-lines to determine the "trigger" point that will initiate the closing transaction. Keep in mind, the price at which the stop-loss order executes must be within the (previously established) maximum loss parameter for that particular trade. For example, an investor who initiates a covered-call with a cost basis of $19.50 and does not want to lose more than $200 (per contract/100 shares of stock) should ensure the stop-loss order is placed above $17.50. If there are no substantial technical support areas near this price, it may be necessary to raise the stop to an appropriate level or, in certain cases, to avoid the position altogether. We can illustrate this concept using EBS (NYSE:EBS) position from last week.

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)

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As you can see, the cost basis ($11.75) in this conservative covered-call is below an established support level, thus the placement of the stop for most traders is relatively easy; it should be somewhere in the range between the bottom of the recent price channel from $12.50 - $13.00 and/or near the point at which the overall position begins to lose money. In contrast, the placement of the stop for someone who wants to be more aggressive is not as simple because the next level of support (near $10) is well below the cost basis of the position.

Obviously, protective stop-loss orders are not perfect; they can be difficult to place effectively and there is risk of loss in volatile markets. At the same time, this technique is a powerful tool for managing losses and the use of a stop-loss order ensures that less experienced traders will focus on one of the most important elements of investing: establishing the exit points before entering a new position.

Next week, we'll review some common adjustment strategies for covered-calls.

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