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Educational Article

A Covered Call Question

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I've been receiving some email questions recently that I'd like to share with you. In my seminars, I always encourage attendees to raise their hand and ask me relevant questions as they come up.

At some seminars, the instructor tells the students to save the questions to the break. Or, hold the questions because he'll eventually get to the answers during the course of the seminar.

I think that's B.S. If someone in attendance has a specific question, it should be dealt with immediately. If one person raises his hand to ask the questions, that means there are others who have the same question, but not the balls to raise their hand.

So, I encourage you to send me specific questions. I'll try to answer them in a timely manner via email.

Question: Hi Mike I just started writing covered calls. My broker told me that it is the most conservative strategy and that I could generate income on stocks that I own. I bought 100 shares of Apple at $172.50 and then sold the $180 call for $2.35. Everything was fine until Apple started to drop. Now it's down at about $120. What should I do? -- Dave

Answer: Hi Dave. I'm not going to sugar coat this for you. If you're a serious trader, you wouldn't want me to.

What do you do? There is an answer, but you're not going to like it. What you do is - learn the damn strategy before you start to trade! Anything you do now is like closing the barn door after all the horses are gone.

The answer is that you just learned a very expensive lesson. The good news is that Apple is still worth about $120 it could be a lot less. You're lucky. Someday Apple might get back to $175 and hopefully you'll still be alive to spend the money. For right now, you're looking at a $50 loss. That $2.35 cushion from selling the call didn't help much, did it? At this point, you have to decide if you still have any confidence in Apple as a vehicle you can use to generate income. If not, sell the stock and put the money to work somewhere where it can do you some good. Perhaps you'd like to grieve over the loss for awhile. But, you have nobody to blame but yourself not Apple, not your broker, not the market YOU!

You started to trade a strategy that you don't understand and you're paying the price. Trading covered calls is DANGEROUS unless you know what you're doing. It's the same as selling a naked put. You were exposed for the full value of the stock ($172.50) with only a relatively tiny ($2.35) cushion. That's not what I, personally, consider a high percentage trade.

When traders start a covered call selling program, they usually end up with a portfolio of losers that have declined so far that it isn't practical to sell options against them. Why? Because if you sell the calls, you're locking in a huge loss. The winning stocks were already called away and you are stuck with what's left.

For example, with your 100 shares of Apple at $120, you might be able to sell the $130 call for $2.00. But, here's the problem. What if you get lucky and Apple moves back above $130? Your 100 shares will be called away. Your cost basis is:
Originally paid for stock: $172.50
Received for $180 call: - 2.35
Received for $130 call: - 2.00
New Cost Basis: $168.15
If your shares are called away at $130, you've locked in a loss of $38.15.

The point to this exercise is that you should never have let Apple get to $120. You shouldn't have allowed it to get to $130, or $140, or $150 or $160. If you're going to play the game right, you have to, at the very least, have a stop loss order in place to close out your short call and your long stock if it reaches the stop loss level. Your broker should have told you that if he's worth a damn.

If your stop loss had been at $165, you would have lost about $7.50 on the stock ($172.50 - $165) and perhaps another $.50 on buying back the short option. That's a total of an $8.00 loss ($7.50 $.50) a lot easier to stomach than a $50 loss. It's no fun to take a loss, but if you're going to be in the options trading business, it's going to be necessary a cost of doing business. You have to preserve your capital.

I strongly suggest you go back through the Option 101 archives and read the four columns I wrote about covered calls. At least then you'll be armed with the concepts one would need to understand before trading this strategy.

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To Begin The Education Process . . .
I know there are many trial subscribers out there who may not have the experience or background to fully understand what we're doing here at the Couch Potato Trader. What we do is not for beginners. It's important to have a solid foundation of knowledge of options and how they work to take full advantage of my column.

Some folks see our track record and are excited (justifiably so) to give us a try. A large percentage of these folks are completely new to options. I'm sure you know a few. We want to make the learning process both smooth and enjoyable.

I have recently agreed with OptionInvestor to teach a two-day introductory options course. We're calling it "Up To Speed." It will start from the basics and go through all the information you would need to comprehend options, what they are, how they work individually and together.

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Please Note
Don't confuse the "Up To Speed" seminar with my CPTI 2-day Advanced Seminar. In the "Up To Speed" seminar, we will be covering the basics and discussing the strategies a new option trader should know.

My 2-day Advanced Seminar starts where the "Up To Speed" seminar leaves off. Those who attend my advanced seminar are there to learn and fine tune their trading skills. It's for those who want to explore more advanced trading strategies further in depth.

Take care and I hope to meet many new friends in the "Up To Speed" seminars.
 

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