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Chapter 5. Options as Cash Generators > Smart Conservative Ground Rules

Smart Conservative Ground Rules

All strategies have positive as well as negative aspects. The covered call strategy is conservative, assuming that you understand the transaction's specific attributes and that you are sure the numbers work in your favor. We must observe seven basic ground rules as we proceed through the analysis to ensure a truly conservative application of the covered call strategy:

  1. Your original purchase price has to justify the strategy. The most conservative use of covered calls is found when you own stock that has appreciated in value. The lower your basis in comparison to today's market value of stock, the more flexibility you have in devising a conservative options strategy. In fact, the use of covered calls is a sensible way to protect a portion of your paper profits without needing to take those profits. For example, if you have a 30-point paper profit, selling a covered call and receiving a premium of 10 ($1,000) gives you 10 points of downside protection, or one-third of your total unrealized profit. If you sell a series of covered calls over time, it is even possible to take all of your profits out of the position without selling stock. For example, if you received a premium of 10 on three subsequent calls over a period of many months, with each one expiring and being replaced in turn, the entire 30 points of paper profits can be taken as capital gains.

  2. The premium value you will receive has to provide enough yield to justify the covered call exposure. If you plan to use your stock as cover for a short option position, you must be able to justify it in terms of profit levels. Check returns from option premium on an annualized basis. So, if you own shares of many different stocks, you will naturally seek out those option positions that yield the best returns. In comparing one option position to another, be aware of the rate of return and the time until expiration. A 5 percent return you earn in 6 months is far more profitable than a 10 percent return that takes 24 months. Also remember that you will not always keep the short position open all the way until expiration. You can close out short positions at any time. For example, one very profitable strategy is to sell a covered call, wait for the time value to decline, and then enter a buy-to-close order, realizing the net difference as a profit. After the position is closed, you can open another covered call using the same stock, but with more time value and profit potential.

  3. You are willing to accept exercise as one of the possible outcomes. In every covered call position, you have to accept the possibility that your 100 shares of stock will be called away. In fact, some investors are drawn to options with the original idea of accepting exercise and selling shares, only to realize that repetitive covered call selling may be more profitable. If you do not want exercise under any circumstances, you should not write covered calls. However, for many investors, covered call writing is a smart alternative to simply selling shares. Keeping shares of stock and the associated dividend income and selling calls to realize short-term profits is one effective way to achieve current returns.


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