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The Easy Way To Manage Risk And Reward With Your Covered Calls

Wednesday, January 15, 2014 - 7:00am

As traders, we constantly deal with various levels of uncertainty. If anyone tells you that they have found a "sure thing" when it comes to your investments, you should run (not walk) in the opposite direction.

Instead of dealing with certainties, we must constantly seek the optimum balance between high probability (having a strong chance of success) and high profitability (generating a high rate of return).

Most of the time, these two dynamics work inversely. If you find a trade that has the potential to triple your money, the probability of that trade will likely be very low. On the other hand, you can set up a trade with a very high probability of success, but the actual return on that trade will likely be small (think Treasury bonds).

As covered call traders, we have a unique ability to pick out specifically where on the probability/profitability continuum we want our trade to sit. Depending on how aggressive or conservative we want to be, we can pick an options contract that gives us the right amount of protection, or the amount of potential returns that we are looking for.

Setting Up Covered Call Positions Based On Probability
For our covered call trades, we can adjust our potential return along with the probability for a successful trade by choosing how far our option contract is in the money (ITM) or out of the money (OTM).

To review, an ITM call option is one that has a strike price that is below the current stock price. For instance, if you bought a stock at $52 per share and sold a call with a $50 strike price, this call would be in the money.

This basically means that if the stock remains above $50, the option buyer will want to exercise his option to purchase shares. He is able to buy shares from you at $50, while the market price for the same shares is above that. Keep in mind that we are well compensated for selling ITM calls because there is a high probability that they will be exercised.

On the other hand, an out-of-the-money call contract has a strike price that is above the current stock price. As an example, we might buy the same $52 stock and sell call contracts with a $55 strike price. This would be an out-of-the-money call option.

Assuming that the stock remains steady at $52, the calls will not be assigned when they expire. This means that we get to keep our stock, but it also means that we don't realize our maximum profit. You see, our maximum profit would be realized if the stock were to rally above $55, allowing us to sell our stock at $55 (and also get to keep the premium we received when selling the calls).

The further out of the money we sell calls, the lower our probability of actually hitting our maximum profit. This is because the stock has to travel a larger distance to actually get above the strike price. But the trade-off here is that the potential return is much larger. This is because we realize a larger profit on the stock portion of our trade as the price increases.

And, of course, the reverse is true for ITM call options. The further in the money the calls are, the higher probability that we are obligated to sell our stock for the maximum profit. This is because the stock has more room to drop and still be above the option's strike price.

With higher-probability trades like this, we sacrifice potential returns. We may set up a trade that has a 95% chance of working, but this trade will not likely give us a tremendous return. So the key for us as traders is to determine how much risk to take on each trade and balance that with the potential return.

Adjusting For Different Market Environments
An interesting dynamic occurs between the tone of the overall market and the way option contracts are priced. When uncertainty is higher (typically during bear market periods), prices for both calls and put options are inflated. And during calm periods (typically bull markets with advancing prices), option prices are much lower.

I won't bore you with the math behind why option pricing works out this way. But I do want to explain how this works to our benefit as covered call traders.

When markets become more volatile, I still want to make an attractive return on my investment, of course -- but my top objective is to protect the capital that I have.

The beauty of the covered call approach is that when markets are more volatile, we get paid more for setting up covered call contracts. This is because option prices are inflated, so when we sell calls against our stock positions, we receive a higher premium.

Since option prices are inflated during volatile periods, I can choose to sell contracts that are further in the money. Remember, ITM calls offer higher probability but lower returns than OTM calls. But that's OK because the entire universe of call options is priced higher with more volatility. So I'm still able to generate attractive returns picking an option that has a higher probability payoff.

And on the other side of the coin, when markets are tame, I can choose to dial up my returns by selling out-of-the-money calls. Sure, I'm taking on more risk, but this is acceptable because the broad market is much less volatile.

Action to Take --> As a general rule, I like to sell in-the-money calls during volatile market periods and out-of-the-money calls when volatility dies down.

This article originally appeared at ProfitableTrading.com:
A Simple Rule for Balancing Risk and Reward in Your Covered Call Portfolio

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Zachary Scheidt does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.