Option Investor

Trading Basics: A Conservative Approach To Covered-Calls
"The ideal investment offers limited risk and a high probability of making a profit."

Traders who understand the benefits of options know they can be used to help generate acceptable returns while affording an above-average amount of downside protection. The technique many people use to achieve this objective in conservative, equity-based investment portfolios is the "covered" call.

A covered-call position involves writing (selling) a call option against stock held in a brokerage account. The buyer of this option has right to "call" the stock at a specific price because he pays the seller of this contract a fee for agreeing to provide the underlying shares if the option is exercised. Because the call writer delivers the shares directly from his portfolio holdings, his short option position is "covered." This means there is no risk to the call writer of being forced to buy (and subsequently sell) shares of a stock at a premium, after it has experienced a substantial increase in value.

While the covered-call writer has no risk of losing money if the stock value rises, there is a possibility of missing out on large gains. The reason is obvious: if a stock moves above the strike price of the sold options and remains there until the expiration date, the call will be exercised and the investor will be forced to deliver the underlying shares. The difference between the value of the stock at expiration and the sold option's strike price is the amount of upside potential lost in the strategy. Fortunately, there is a trade-off for this shortcoming: if the stock moves lower, the investor will offset part of his loss by the amount of money received from the sale of the call option.

Choosing the "Right" Covered-Call

Considering the recent volatility in the equity markets, a strategy based on stock ownership that offers moderate profit potential and relatively low risk is appealing. The covered-call aptly fulfills these criteria with a simple, easy-to-manage stock/option combination that performs well in all but the most bearish market conditions. While the majority of traders write in-the-money calls (ITM) to establish conservative, short-term positions, experienced investors often strive for higher, more aggressive returns by selling out-of-the-money (OTM) calls on portfolio-quality issues. The latter method offers greater potential rewards but also has less downside protection because the maximum profit for an OTM position, while generally higher than that of an ITM position, is dependent on an increase in the price underlying stock. Indeed, by selling an OTM option, the investor is relying more on the movement of the stock and less on the benefits of writing the call. Furthermore, the amount of money generated from the sale of the call is generally much smaller, thus the combined position will be more susceptible to loss if the stock declines.

Covered-call positions involving ITM options are more defensive, offering less risk with smaller reward potential. This conservative approach appeals to those investors who are attempting to earn a relatively consistent return while striving for preservation of capital. Despite having a smaller profit potential, the ITM approach can be very attractive on a percentage return basis. The cost of the underlying issue is substantially reduced and even if the stock declines, the position can still return a profit. Traders who use the strategy in this manner consider both downside protection and potential profit when evaluating candidates. The combined (stock and options) position is viewed as a single entity and the investor is not overly concerned with long-term ownership of the underlying issue. Not surprisingly, this low-risk/low-profit mentality is one of the keys to consistent success for many covered-call writers.

Regardless of the approach you favor, a comparison should always be made with regard to the various option strikes and prices. More importantly, investors who plan to sell OTM calls should evaluate each position with regard to the "return not called." This is the return on investment that one would achieve even if the stock price were unchanged when the sold options expire. A person can compare potential trades impartially using this method, since no assumption is made about price appreciation in the underlying issue. Although our OTM covered-calls portfolio is somewhat aggressive with target returns up to 10% per month, we also strive to establish positions with downside protection of at least 5% of the current stock price. The basis for this methodology is two-fold. First, any covered-call play constructed using these guidelines will have comparatively low risk (regardless of the volatility of the underlying issue) due to the substantial levels of downside protection and second, there is still the expectation of a reasonable return.

Since the primary objective of covered-call writing is increased income though stock ownership, the amount of downside protection and the return on investment are both important elements in determining which approach to use. At the same time, determining a minimally acceptable return is a matter of personal preference, thus two individual portfolios are necessary to provide viable candidates for the majority of investors.

Portfolio I: Conservative - ITM Calls

The basic objectives of the ITM Covered Call-Writer are as follows:

1) To generate consistent income by selling high-value (in-the-money) options on stocks in a neutral to bullish trend, with a focus on having the underlying issue called away at the end of the expiration cycle. Although this approach produces a large number of successful trades, position adjustments will occasionally be needed in the interest of capital preservation and sound money management.

2) The profits achieved through a diverse selection of these covered-call plays should yield gains of 2-4% monthly, based on (minimum) 500 share/5 contract trades and without regard to commission costs. The use of margin can increase the potential profit in each position, but it is not essential to the success of the strategy. Any income from positions held in a ROTH IRA is tax-free (and tax-deferred in a traditional IRA).

3) In most cases, the options sold in these positions will be exercised (and the stock will be assigned) at the end of the expiration period. Because the short options are ITM, there will generally be a capital loss when the stock is sold. The funds received from the sale of the calls will more than offset this debit, thus yielding a profit in the combined position.

4) All of the published candidates will be pre-screened for this strategy, however each position must be thoroughly evaluated with regard to your personal risk tolerance, experience level and portfolio outlook.

Portfolio II: Speculative - ATM/OTM

The basic objectives of the ATM/OTM Covered Call-Writer are as follows:

1) To generate income through capital appreciation of stocks in a bullish trend. The sale of options with excess "premium" will be used to reduce the cost basis in the underlying issue. This approach will produce fewer successful trades, but with larger capital gains.

2) Since the success of an ATM/OTM covered-call is based primarily on the movement of the underlying issue, the sold options play a smaller role in the outcome of the trade. The cash received in the initial transaction is intended to lower the overall basis of the position (providing additional downside margin for market volatility), but it will not offset a substantial decline in the stock. Obviously, position adjustments will be more frequent in order to lock-in profits and limit losses.

3) The profits achieved through a diverse selection of these covered-call plays can yield up to 10% monthly, based on (minimum) 500 share/5 contract trades and without regard to commission costs. The use of margin can increase the potential profit in each position, but it is not essential to the success of the strategy. Any income from stock sales in a ROTH IRA is tax-free (and tax-deferred in a traditional IRA).

4) Stocks in this portfolio may be held through multiple option-expiration cycles, as long as the technical character remains favorable. In addition, OTM covered-call positions can frequently be closed early for favorable gains, due to upside activity in the stock or time-value erosion in the short options.

5) All of the published candidates will be pre-screened for this strategy, however each position must be thoroughly evaluated with regard to your personal risk tolerance, experience level and portfolio outlook.

In order to help subscribers achieve this goal, we will...

1) Publish a variety of viable covered-call candidates once each week (Saturday) with time frames of up to two months prior to the option expiration date. The candidate lists will include a stock to purchase as well as a specific call option to be sold against the underlying issue. In addition, we use a proprietary scan/sort process to review all of the covered calls listed in portfolios, thus reducing the research time required for potential plays.

2) Provide guidelines to implement the strategy, including common entry and exit techniques as well as effective methods of position management. We outline a step-by-step process that utilizes a combination of stocks and options to reduce the effects of market volatility and create a consistent cash flow. Even if you have no experience with derivatives, you can learn to generate monthly income with as little as $2000 in a brokerage account. In short, we teach you how to risk less and make more, thus maximizing your portfolio's profit potential.

3) In all cases, understand that writing covered-calls is not a "get rich quick" strategy. It is a slow, methodical process that requires compounding nominal income over time to achieve wealth. To be successful, you must never "fall in love" with any issue. If your stock is called away, the trade is profitable and you have realized the maximum gain available. If not, you must evaluate the current outlook for the underlying issue and decide whether to write additional calls or exit the position in favor of a new candidate. As the saying goes, "winners take care of themselves" and when you learn to manage losing plays effectively, your account balance will grow consistently, regardless of market conditions.

Trading Basics: What is a Covered Call?

Many of our new readers are comfortable with investing in stocks but are hesitant about trading options. Selling "covered" calls is a strategy that may be appropriate for their experience level.

Buying stocks is one of the most popular investing techniques in today's financial markets. Derivatives are a natural companion to stock ownership and yet most people never benefit from the advantages of options because they believe they are too "risky." It is true an option buyer can lose the entire value of their investment however the same situation exists when buying stocks. One way to limit the potential downside of stock ownership is to transfer some of the risk to another trader by writing "covered" calls on the issue. A covered call is like placing a limit order to sell the shares to someone else at a specific price (the strike price) after it is purchased. For this obligation, you receive a premium, which lowers the overall cost basis of the issue. In return, you forego a certain amount of upside potential in the stock. Investors who use this strategy are interested in earning consistent (moderate) profits while maintaining an above-average downside margin during periods of bearish market activity.

The characteristics of the covered-call position are fairly simple and the first requirement is stock ownership. When you sell (write) a call option against portfolio shares (one contract for every 100 shares owned), you agree to sell your stock at a specific price - the strike price of the option - for a given amount of time (until the option expires). In the transaction, you receive a certain amount of cash from the option buyer for their right to buy your stock, and you get to keep this money regardless of what happens to the stock in the future. At expiration, there are two possible outcomes:

1) If the stock price rises above the strike price of the sold option at expiration, the stock will "called" away (assigned) by the owner of the option. When this event occurs, you realize a profit, providing that your cost basis in the issue is less than the strike price of the option that you sold.

2) If the stock price is below the strike price of the sold option, it will not be assigned and you keep the stock for future trades, such as selling additional options for more cash income. One thing to remember is the stock can be assigned at any time prior to the option expiration date, regardless of its price, so don't write calls against a stock you are not willing to sell.

Here is a profit/loss graph for the covered-call:

[Graph: Profit-Loss]

Despite the apparent simplicity of this strategy, writing covered calls involves a number of key decisions, the most important of which is whether you want to be conservative or aggressive in your approach. An investor with an aggressive attitude and a bullish outlook on the market would probably sell options at strike prices that are higher (out-of-the-money) than the current price of the stock, thus his potential profit would include both the cash received from the sold options plus any capital appreciation (up to the option's strike price) of the issue. A more conservative investor might sell options with strike prices that are near (at-the-money) the current price of the stock, thus establishing a relatively balanced outlook with regard to risk and reward. The most loss-adverse investor would construct positions using options with strike prices that are below (in-the-money) the current price of the stock, creating a stock-option combination with a high probability of a limited, but acceptable, profit. The key to success with this approach is to carefully calculate the potential gains in each of these situations, based on the adjusted cost basis in the issue.

Regardless of what method you favor, there are a few guidelines that apply to writing covered calls in general. First, the expiration date of the sold calls should be no more than a few months in the future because an option's extrinsic value (on a relative basis) is greatest in near-term options. Second, options which are at-the-money provide the highest amount of theoretical premium, based on the normal distribution (bell curve) of option pricing. Third, lower priced stocks will offer better yields in covered-call positions, especially when the stock is purchased on margin. Obviously, selling an at-the-money call for $1 on a $10 stock is more effective than receiving the same premium for a similar option on a $20 stock. Finally, commissions can play a significant part in the calculations of potential profits as there are generally three trades in a successful play; the purchase of the stock, the sale of the call(s), and the sale of the stock upon assignment. Experienced investors offset this effect by purchasing a minimum of 500 to 1000 shares in each position.

One trading strategy worth noting involves the entry transaction for covered-call positions. The technique in question is called a "buy-write" order, and it can be very a useful means to establish the overall profit/loss outlook in a covered-call. In simple terms, a buy-write order entails buying stock and selling an option simultaneously. When placing an order for a buy-write, you request to purchase a specific number of shares and sell an equivalent amount of (call) options for a specific "net" price, with both transactions occurring at the same time. One of the advantages of this technique is that it prevents the possibility of "slippage" during the position entry process, when the price of the call option declines. This dilemma happens frequently with covered-call plays as many are initiated during the first hour of trading on the Monday after the previous month's options expire. If too many calls are sold without any buying pressure, the bid price drops quickly towards intrinsic value and the profit potential becomes unfavorable. Traders who attempt to "leg-in" to their positions (buying the underlying issue with plans to sell calls later) are often surprised to see the previously overvalued options deflate before they can be sold in order to "cover" the stock.

The strategy of writing covered-calls works well for a variety of financial instruments in virtually any market conditions. In addition, the covered-call is also considered to be one of the safest ways to learn about option trading. The primary advantage of this technique becomes apparent as you compare the outcomes when the underlying issue moves in a narrow (lateral) range. During bullish cycles, capital gains are an important part of equity ownership however the opportunity cost of extensive upside activity is usually more than offset by the protection afforded during bearish technical trends. In those instances where retaining portfolio stock is a priority, the short options can be repurchased (or rolled to a higher, more distant strike) to eliminate the obligation of the original contract. As with any strategy, covered-call writing has advantages and drawbacks but ease of management and consistent income are most compelling attractions for the average investor.