Covered Calls

[m_winston]

Nice article on covered calls in Barrons.........................


SATURDAY, DECEMBER 6, 2008
THE STRIKING PRICE

"Buy-Writes" Soar in Favor
By STEVEN M. SEARS

Using "buy-writes" to profit from battered stocks.
LIKE ALCHEMISTS TRYING TO TURN LEAD INTO GOLD, options traders are trying to convert volatility into money.

"Buy-writing," a classic strategy that refers to buying a stock and selling ("writing") an out-of-the-money call on it, is attracting enormous interest from investors seeking to harness volatility. The "buy-write" lowers the cost of buying the stock by the amount received for selling the call, and also serves as a modest hedge. Option premiums are exceptionally high at the moment because of the record levels of volatility, so sellers are getting princely sums.

The strategy's benchmark is the Chicago Board Options Exchange's S&P 500 BuyWrite Index, or BXM. In October, it had its largest monthly gain in 20 years -- 8.1% -- well above its two-decade average of 1.7%.

Many investors are using buy-writes to lower the cost of already battered stocks that they want to cherry-pick. But doing this successfully requires discipline. That's why we spoke with Michael Schwartz, Oppenheimer & Co.'s chief options strategist, who has guided investors through the markets since 1965. Here are his buy-write rules:

• Stock selection is primary, getting a premium is secondary. Pick stocks that you want to own, not calls that you want to sell.

• Never invest more than 10% of your capital in a buy-write. Leverage cuts two ways.

• Sell slightly out-of-the-money calls to leave room for upside profit potential. (Institutional investors often pick calls that are 10% or more out-of-the-money and carry premiums of $1 or more, though many are now taking less than $1 because stock prices are so low.)

• Let time work for you. You can sell three- to six-month calls for higher premiums.

• Don't annualize returns. Focus on the potential return for the trade's actual duration; annualized returns are rarely earned.

• Ignore theoretical values. Expensive options stay expensive longer than expected, and vice versa. The current correction has shown that volatility, which always reverts to its mean, may not do so when expected.

• Don't sell the call and try to buy the stock at a better price. This leaves you with a "naked call" and unlimited market risk. Enter buy-writes simultaneously. A net debit order is entered for any combination of prices to buy a stock and sell a call that equals your desired debit ($30 stock price less $3 option price equals $27 net debit).

• If stock fundamentals change, sell the stock and buy back the call.

• If you can earn a high percentage of the maximum profit before expiration, do it. Waiting for the last 10% to 15% of premium often means risking everything for no more than an incremental gain.

Perhaps the biggest benefit of buy-writes is that they give investors a way to handle panic. Says Schwartz: "You don't have to be afraid of volatility. The buy-write strategy lets you use the stock market's fear to your advantage."