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The 6-Week Options Trading Kickstarter: Covered Calls

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Steve Smith breaks down a popular options strategy.

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MINYANVILLE ORIGINAL

Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. Note: Intermediate or advanced-level traders may get more mileage out of Minyanville's 9 Weeks to Better Options Trading series.

Covered calls are among the most popular options strategies pushed by sell-side brokers and employed by traders.

But the reasoning behind both sides' attraction also exposes some myths that retail investors should be aware of before embracing this approach. Let's take a look at the pros and cons.

A covered call is created by being long a stock, and short call options on that same stock.

Typically, one call is sold for every 100 shares of stock.

If the positions are created simultaneously it is often referred to as a "buy/write."

The premium received from the sale of the calls reduces the effective cost basis of the stock, providing some downside protection, and a potential boost – or reduction -- in returns depending upon the price action.

Let's look at an example.

On Monday, with IBM (NYSE:IBM) trading at $200 per share, one could sell the September $205 calls for $1.80 per contract.

As with all options positions, there is a tradeoff between the benefits and costs. While the downside is cushioned a bit, the potential upside is capped as the stock will be "called away" if it is above $205 at expiration. In other words, if the stock is above $205 at expiration, the buyer of the call option will exercise his or her right to take ownership of the stock at a cost of $205 per share.
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

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