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Covered Calls

Covered calls are not a difficult asset class for investors to use, but it is one of the least used. It has great flexibility and can help reduce volatility in a portfolio.

Buying a stock and then agreeing to sell it at a specific price at the time of purchase is one way of choosing an end point for a trade. The nice part is than you can anticipate profit and loss at various price points as well.

There are 3 things a stock can do after you purchase it. It can go up, it can stay the same or it can go down. When you put on a covered call position, 2 of the 3 are OK for you.

You can choose to write calls near the price of the stock which is called “at the money.” You can write a call that is "out of the money" if you are very bullish on the stock. You may also write an "in the money" to be more conservative, increase probability of profit, but reduce return.

Let's look at a possible candidate for a covered call and some of the options available to the covered call writer (All numbers and stock symbols are based on information available June 2005). CYBX is a stock with a new technology. Cyberonics, Inc., CYBX engages in the design, development, and commercialization of medical devices, which provide a therapy, Vagus Nerve Stimulation (VNS), for the treatment of epilepsy and other debilitating neurological, psychiatric diseases and other disorders. The company is conducting clinical studies of the VNS Therapy System for the treatment of depression in patients with depressive episodes that have not responded to standard treatments.

As of the close of business on June 17th, 2005, an October 2005 call would have 120 days to expiration. The stock closed at 39.47. The calls looked as follows:

October 35 call $10.00
October 40 call $7.50
October 45 call $5.40

For this example, an "at the money" call would be the October 40 for a $7.50 premium. If the stock closes at 40 or higher 120 days from now, the option writer would earn the $/53 profit plus the $7.50 option premium for a very nice 20% return for 120 days.

The October 35 call would only return about 10%, but the stock could even drop 4 ½ points to get that return.

Imagine writing these options every 120 days.