A strategy idea for options trading investors.
Covered Call Trade
When looking to find possible covered call candidates, a trader or investor will look to find a stock that is stagnant but overall slightly bullish. The current market condition has been a little unstable to say the least but this is one of the benefits of a covered call. Investors are looking to protect a solid stock that might be going through a rough patch by offering some down-side protection.
Allergan Corp. (NYSE: AGN) is probably most famous for being the maker of Botox. AGN has been a slightly bullish stock for the last two years with a couple of pullbacks mixed in. Since the end of 2008 it’s gone from about $35 to its current price of about $84. The last two months it has drifted sideways between $79 and $84.
The theory on this covered call is this:
AGN has faired well in this bearish market. It’s had a strong run up since the end of March 2011 and has stayed in the top one-third of that climb which is usually a bullish sign. The stock seems to have support at the $78 — $79 area. July expiration only has 18 days left until expiration so we will look for August expiration calls. This will give the stock a longer time to rise and provide us with some additional premium because of the longer expiration. As recently as May 18, AGN traded as high as $85.74 so we’ll look to sell the 85 strike because we know it is possible for the stock to get to that level. This AGN covered call trade is structured for maximizing returns on a stock position but it also offers some protection if it dips.
Allergan Corp. — $84.01
Buy 100 shares of AGN @ $84.01 and sell the AGN August 85 Call @ $2.35
Cost of the stock: 100 X $84.01 = $8,401 debit
Premium received: 100 X $2.35 = $235 credit
Maximum profit: $334. That’s $99 (85 – 84.01 X 100) from the stock and $235 from the premium received if AGN finishes at or above $85 @ August expiration.
Breakeven: If AGN finishes at $81.66 (84.01 – 2.35) @ August expiration.
Maximum loss: $8,166 if AGN goes to $0 @ expiration.
The goal for any covered call strategy is for the stock to rise up to the sold call’s strike price. That way the stock moves up the maximum amount without being called away and the sold call expires worthless.
As always, if the stock moves past $85 and looks like it’s not going to slow down, then the Aug 85 Call that was sold can be bought back and a higher strike can be sold against the position. This will allow the stock to remain in the portfolio and also give the position a chance to increase its return.
The company is scheduled to announce earnings on August 3. If the position is profitable before earnings, profits can be taken since earnings can be unpredictable.
Remember though, every trade should have defined risk and loss parameters in place.
Dan Passarelli of MarketTaker.com writes the Market Taker Edge options newsletter. Dan has more than 17 years’ experience in the options industry as a market maker, Options Institute instructor and author of “Trading Option Greeks.”