p Ken Trester, Managing Editor p Jeff Carter, Senior Editor p Ron Jackson, Publisher

"Covered option writing is a rational and rewarding approach to the market" - Ken Trester

The best way to introduce you to covered option selling (writing) is to look at this approach to the options market as a business, not a strategy, or a game, or an investment. 

Covered option writing is a business, just like running a book store or a supermarket. 

When you enter the business of option writing, the merchandise or inventory that will be on your shelves will be common stocks that have listed options. 

The objective of your business is the same as any other business — to generate a cash flow and income. 

You generate this income from your merchandise — your common stock — by writing options against it. 

Most investors purchase a stock with the hope that it will appreciate in value through an increase in price. 

But with covered option writing, we are not involved in such a "hoping" and "praying" game. 

As a business manager running a covered option writing program you are not concerned with significant stock price increases. 

You are primarily concerned with generating a high cash flow, not from hoped-for movements in the stock price, but from the continual writing or selling of options against that stock, against the merchandise you have on your shelves. 

Covered option writing is a rational and rewarding approach to the market. If you own stock, you should be involved in the business of option writing, generating a cash flow and income from that stock. 

If you are not, you are letting that stock go to waste. 

You are allowing your inventory to sit on the shelves, not opening your store for business. 

When you own rental property, you rent it, or when you own a book store, you sell books. You don't lock the doors and hope the books will increase in value over the years. 

The same analogy applies to stocks. 

The Pros Of Covered Option Writing
The major advantage of covered option writing is that it reduces your risk of owning stock. 

For example, you own 100 shares of XYZ stock, currently priced at 19-3/4. Your risk in holding these shares is $1,975, the total value of the 100 shares of stock. 

If in July you were to write an XYZ Nov 20 Call option priced at 2, you would immediately receive $200 in your account (one option represents 100 shares of stock, so an option priced at 2 is worth 2 x 100, or $200). 

This is in effect a cash refund, or discount of $200 on your stock. 

As a covered option writer or seller you have now become a strategic investor. 

If the stock price has not changed by the end of November, you are guaranteed a cash return of 10% for a four-month period of time. 

If you are able to continue writing options like this, over the course of a year you may receive option premiums equal to up to 30% of the value of your stock, a terrific return on your investment. 

You have also bought an insurance policy with $200 worth of downside protection. If the stock price drops two points, your option income covers your paper loss. 

Conversely, the typical investor does not write covered options; he holds onto his stock and hopes to reap high profits if the stock rises significantly. 

He has not received any insurance whatsoever, or any return on his investment. 

By writing covered options you partially reduce your risk of stock ownership. 

In fact, if a stock price continues to fall, you can buy back the option you have written for a lower price, then write another option against your stock with a lower exercise price and different expiration date. 

Referring to our previous example: 

Suppose that XYZ stock falls from 19-3/4 to 16, and your Nov 20 Call option is now priced at 1/2. You can buy back the Nov 20 Call for a profit of $150 ($200 minus $50), less commissions. 

There may also be an XYZ Feb 15 Call option available priced at 3-1/2. If you write this 

option, you will receive $350 in additional cash to protect your position and add to your gross profits of $150. 

Should your stock continue to fall, you can buy back options and continue writing options to provide additional insurance and cash flow to your portfolio. 

In this way, you reduce your downside risk of your stock position. 

Though this strategy may look like a super deal for a covered option writer, in reality sometimes the stock price falls too rapidly to enable a writer to roll over into a new option, or the prices of the new options may be too low to make them a worthwhile play. 

At this point you must now be a smart investor and consider cutting your losses by selling the stock. (Make sure that you have closed all your option positions before you do). 

The Cons Of Covered Option Writing 

For your $200, you have taken on the obligation to deliver the stock to the buyer of the option at a price of 20 any time before the option expires in November. 

If the stock moves down in price, the option will not be exercised. 

But if the stock rises from 19-3/4 to 26, you would not participate in the total price move. 

Once the stock price moved above 22, it would be profitable for the option buyer to call the stock (the strike price of 20 plus the option price of 2 = 22, the buyer's break-even point). 

But even if the 100 shares of XYZ are exercised (called) by the option buyer, you would still have a locked-in profit of $225, less commissions. 

So as a covered option writer you cannot take total advantage of big moves in the stock price.

Your profit opportunity is limited if the stock makes a significant upward move. 

But there is a way to offset this disadvantage. 

Simply buy back the option that you wrote, which closes your position and liability to sell the stock, and you'll continue to participate in further stock price gains.

For more information about covered call writing and other profitable options strategies click here.