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December 30, 2008

# Covered-Calls 101

HAVING TROUBLE PRINTING?

Covered-Calls Q & A

This week's article is devoted to answering some common questions about covered-calls and the CCS Portfolios.

1) How do you calculate potential gain/profit for covered-call positions?

2) What is a reasonable profit target for investors who use this strategy?

3) Should the average investor use margin when buying stocks for covered-calls?

4) Are there some basic guidelines for success with stock and option trading?

First, we will review the common profit (and loss) formulas for covered-call positions.

The calculations utilized to determine potential profit or return on investment (ROI) with covered-calls can be divided into two categories: Return Called (RC), and Return Not Called (RNC). Many traders focus on the RNC when evaluating similar covered-call candidates since there is no assumption made about the movement of the underlying equity. To compute this number, you simply take the net cash received from the sale of one call option and divide it by the cost basis of the position. The cost basis is the price per share of the underlying stock minus the cash received from the sale of one call option contract. (Note: This is also the minimum amount of equity, without using margin, required to initiate the position).

Return Not Called (RNC) Calculation:

Buy XYZ stock for \$12.00 per share Sell MAR-\$12.50 call for \$0.50 per contract Cost Basis = \$12.00 - \$0.50 = \$11.50 RNC = \$0.50 / \$11.50 = 4.3% (stock unchanged at \$12.00)

For in-the-money (ITM) positions, determining the Return Called involves a similar process. The maximum profit is equal to the price of the sold option minus the difference between the cost of the stock and the option strike price. As you would expect, the in-the-money RNC is the same as the RC, since the sold (call) strike is below the stock price. Regardless of the share value, this is the maximum return on investment.

In-The-Money RC Calculation:

Buy XYZ stock for \$12.00 Sell MAR-\$10.00 call for \$2.50 per contract Cost Basis = \$12.00 - \$2.50 = \$9.50 Max Profit = \$2.50 - (\$12.00 - \$10.00) = \$0.50 RC = \$0.50 / \$9.50 = 5.26% (stock unchanged at \$12.00) RNC = RC

For out-of-the-money (OTM) positions, the RC can be substantially higher than the RC, depending on the movement of the underlying issue. In this case, the maximum profit is equal to the price of the sold option plus the difference between the cost of the stock and the strike price. When the stock price increases, the RC moves up as well, until the sold (call) strike is in-the-money. In contrast, the RNC does not increase because it based solely on the cash received from the sale of the option (and assumes the stock price remains unchanged).

Out-Of-The-Money RC Calculation:

Buy XYZ stock for \$12.00 Sell MAR-\$12.50 call for \$1.00 per contract Cost Basis = \$12.00 - \$1.00 = \$11.00 Max Profit = \$1.00 + (\$12.50 - \$12.00) = \$1.50 RC = \$1.50 / \$11.00 = 13.64% (stock at or above \$12.50) RNC = \$1.00 / \$11.00 = 9.09% (no benefit from stock appreciation)

After the potential return on investment is ascertained, the process can be carried one step further to provide a better basis for comparison. This involves converting the gain or ROI to a monthly time-frame. Using the ITM-RC example above, a 5.26% profit earned in a 3-week (21 day) period could be characterized as follows:

ROI = 5.26 / 21 days X ( 365 days / 12 months) = 7.61% per month

Essentially, the return is annualized and divided by twelve to produce a monthly basis. This helps investors to visualize the value of compounding a seemingly small return over and over again. Of course, commission costs are not included in the ROI calculations as they vary depending on which brokerage and what level of service is provided. In addition, the purchase of common lot sizes such as 500 or 1000 shares will negate much of the impact of this expense.

Position Selection: More Profit = More Risk!

The candidates in the Covered Calls System portfolios are selected to help different types of investors achieve favorable gains on a diverse group of stock holdings while providing reasonable downside protection against unexpected share price activity. Since the covered-call strategy can be used effectively in a variety of market environments across a range of time frames, we provide three basic categories of plays: conservative, speculative, and longer-term. In the conservative portfolio, the objective is geared towards the success of the average investor; it seeks to identify short-term trades that have a high probability of making an acceptable (and consistent) profit. Using this methodology, the "in-the-money" positions are targeted to achieve gains of 2 to 4 percent per month, when averaged on a yearly basis. The longer-term portfolio uses much the same criteria but with sold calls that are typically "at-the-money" or closer to the current price of the underlying issue, in order to generate the additional option premium needed for a holding period of 30-50 days. The primary purpose of the speculative or "out-of-the-money" portfolio is to profit from the capital appreciation of stocks in a bullish trend. The success of this approach is based almost entirely on the movement of the underlying issue so there is a large range for gain and loss, however the cash received from the sale of call options reduces the overall cost basis thus improving the chances of a profitable outcome.

Although the covered-call strategy can be utilized in conjunction with "buy-and-hold" stocks, we favor positions where success isn't predicated on forecasting an issue's directional trend for extended periods. Remember, writing covered-calls will provide a small hedge against downside movement in the stock but the technique is not a remedy for protracted bearish activity. The use of the strategy is always predicated on a neutral to slightly bullish outlook for the underlying equity and its associated sector/industry group. In addition, selling covered-calls requires a disciplined approach and sound money-management techniques as there is risk of loss in all forms of stock and option trading. As with any investment, it remains your responsibility to perform due diligence and thoroughly research each issue you are interested in adding to your portfolio.

Using Margin With Covered-Calls

Our new subscribers often ask if we recommend the use of margin in covered-call positions. Before you consider using margin, it's important to be aware of the guidelines brokers have established for this type of trading. To initiate and maintain a margin account, a minimum of \$2,000-\$5,000 in any combination of cash or marginable securities is required to be on deposit at your brokerage. In addition, margin accounts are obligated to maintain certain minimum equity levels; generally at least 30% of the portfolio value. If the market value of your margin account declines below that ratio, the broker may request that you deposit more collateral through a "margin" call. A margin (maintenance) call should always be answered promptly with the delivery of additional securities or funds to avoid liquidation of portfolio holdings.

As most of you know, the market has been rather difficult in recent weeks and the deluge of conflicting outlooks and forecasts has demonstrated why each of us must work hard to overcome our emotions and think independently. At the same time, it is also important to reflect on our previous failures and use that knowledge to avoid the same mistakes in the future. Here are some important concepts professional traders have identified from their past trading experiences:

1. Trading demands foresight, flexibility, patience, common sense and above all, sound judgment executed in a timely manner.

2. Distribute risk with portfolio diversity, and avoid financial uncertainty with hedged positions.

3. Trade with a plan, and know your limits before you open any position! Always predetermine each entry and exit target.

4. Manage your losses successfully and profits will soon follow!

5. Don't be influenced by outside forces, including friendly advice. Ignore the crowd and think for yourself!

6. When hope becomes a major part of your outlook, it's time for a break. Fall back, take inventory, redefine your motives and try again.

7. Momentum traders: Buy on weakness, and add to your position as the rebound above a trend-line (or moving average) confirms the upside potential.

8. Momentum traders: Sell on strength, and close out winning positions at the first sign of hesitation. Protect your profits with trailing stops.