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Traders who understand the benefits of options know they can be used to help generate acceptable returns while affording an above-average amount of downside protection. The technique many people use to achieve this objective in conservative, equity-based investment portfolios is the covered call.

Considering the recent volatility in the equity markets, a strategy based on stock ownership that offers moderate profit potential and relatively low risk is appealing. The covered-call aptly fulfills these criteria with a simple, easy-to-manage stock/option combination that performs well in all but the most bearish market conditions. While the majority of traders write in-the-money calls (ITM) to establish conservative, short-term positions, experienced investors often strive for higher, more aggressive returns by selling out-of-the-money (OTM) calls on portfolio-quality issues. The latter method offers greater potential rewards but also has less downside protection because the maximum profit for an OTM position, while generally higher than that of an ITM position, is dependent on an increase in the price underlying stock. Indeed, by selling an OTM option, the investor is relying more on the movement of the stock and less on the benefits of writing the call. Furthermore, the amount of money generated from the sale of the call is generally much smaller, thus the combined position will be more susceptible to loss if the stock declines.

Regardless of the approach you favor, a comparison should always be made with regard to the various option strikes and prices. More importantly, investors who plan to sell OTM calls should evaluate each position with regard to the return not called. This is the return on investment that one would achieve even if the stock price were unchanged when the sold options expire. A person can compare potential trades impartially using this method, since no assumption is made about price appreciation in the underlying issue. Although our OTM covered-calls portfolio is somewhat aggressive with target returns up to 10% per month, we also strive to establish positions with downside protection of at least 5% of the current stock price. The basis for this methodology is two-fold. First, any covered-call play constructed using these guidelines will have comparatively low risk (regardless of the volatility of the underlying issue) due to the substantial levels of downside protection and second, there is still the expectation of a reasonable return.

Since the primary objective of covered-call writing is increased income though stock ownership, the amount of downside protection and the return on investment are both important elements in determining which approach to use. At the same time, determining a minimally acceptable return is a matter of personal preference, thus two individual portfolios are necessary to provide viable candidates for the majority of investors.