Thursday, September 13, 2007

Are You Ready For Some Covered Calls?

On Monday Night Football, ESPN has Hank Williams, Jr. again this year singing “Are You Ready For Some Football?”
Here, we ask a similar, but really very different question: “Are You Ready For Some Covered Calls?”

Are you currently investing in covered calls as part of your investment portfolio? If so, think back to when you made your first covered call trade. What made you decide that you were ready for covered calls? If you’re anything like me, you sort of slowly ‘eased in’ to covered calls. In my case, at my first job after college, I was working in the same office with two other young fellows who, along with me, were interested in stock investing. We did the work we were supposed to be doing, but we also managed to intersperse our assigned tasks with the equivalent of about 2 hours per day of stock market conversations. So, because of my natural interest in investing, but perhaps also because I wanted to hold up my end of the conversations, I began to read everything I could get my hands on in the local public library about the stock market. It took me about 2 years to gain enough confidence (and more importantly to save enough money), to open a brokerage account (anybody remember a company named Johnston, Lemon?) and to buy my first stock (anybody remember a company named Gulf & Western?). For the next 3 years I continued to slowly add more stocks to my account. Then, during a bear market period, I decided it would be wise to sell some options against my stock holdings in order to obtain some additional income and to get some downside protection. Little did I know then that I was beginning to use a strategy that would ultimately become the cornerstone of my investing approach.

I suspect that many of you could craft a similar story that describes how you also ‘eased in’ to covered call investing. But this article is really intended to primarily serve as advice to those who are interested in the possibility of investing in covered calls, but who are not yet comfortable with making the decision to ‘jump in’ (or at least ‘ease in’).
How much do you really need to know about covered calls before you make your first investment? A flippant answer would be ‘as much as possible.’ But really, how much is enough? To assist you in answering that question for yourself, I've devised a simple test that will help you assess if you are ready. In this regard, understanding key terminology of covered call option writing is a good indicator of your own knowledge and readiness. If you can provide a short explanation of what each of the following four terms are, then you are probably prepared to begin -- the four terms are: (1) Annualized Return If Exercised, (2) Downside Protection, (3) Open Interest, and (4) Implied Volatility. Don’t be concerned right now if you are clueless about the meaning of these terms. In fact, I strongly suspect that there are several people that will read this who are already active covered call investors and who will have to admit that they can’t really explain the meaning of these terms either. So rather than becoming discouraged, instead challenge yourself to find a knowledgeable person, or a website, or a book (or preferably all three) where you can learn these important covered call terms as you prepare for your first covered call investment.

I’d like to issue a caveat to you regarding this terminology test. It is meant to be a convenient way to get a relatively quick assessment of your covered call investing readiness. But no simple test or guideline can tell you precisely when is the right time for you. Only you can make that determination for yourself. In this advisor’s recent article there is a short description of the importance of using your own ‘gut feeling’ as a portion of determining your outlook for the short-term direction of the overall stock market. Using your gut instinct is also a very valid approach when it comes to deciding when you are ready to start investing with covered calls. You will have your own personal sense of when it is the right time for you to begin (‘ease in’ if you will). My advice to you is to ‘trust your own instincts’ -- they'll help you to sense when you have reached that comfort level wherein it will just seem right to begin. You will always have some apprehensions, but once begun, covered calls investing will likely prove to be both an interesting and profitable adventure for you. So, the sooner you prepare yourself to the point where you're ready to begin, the better.

Right about now you're probably asking yourself: "Well, what should I do now? Where do I begin?" As part of your covered calls education, there is a book that I strongly commend to your careful reading. In this advisor’s opinion, it is the single best book now available for learning about covered call investing (including the four terms above and many more). It is ‘New Insights On Covered Call Writing’ by Lehman and McMillan. It is very worthwhile reading for the novice and experienced investor alike because it explains both basic information as well as key strategic concepts; and fortunately it is presented in a very clear writing style. Please check it out – and if you’ve already read it, then follow my lead and read it once again. As covered call investors, the more we read the more knowledge we gain and the better and more savvy we become in our investing decisions.

If you have any specific questions about this article, or anything else related to covered calls, please post a ‘comment’ at the link below. Also, if you are not already a member of the Yahoo Groups ‘justcoveredcalls’ on-line discussion group, then consider joining now. The posts made on that site are generally both interesting and educational; and there are several knowledgeable, successful, and helpful covered call writers there who are more than willing to respond to any of your comments and questions.

Regards and Godspeed to All

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