A strategy idea for options trading investors.
When looking to find possible covered call candidates, a trader or investor will look to find stock charts that are slowly going up. The general thought on the strategy is to find a stock that is stagnant but overall slightly bullish. The current bearish market condition makes it a little bit harder to find suitable plays than a bull market, but they are out there. Let’s see what looks good this week.
Stock/Underlying – Teradata Corp. (NYSE: TDC)
Teradata has been a bullish stock since the end of 2008 when it was about $12. It went sideways for most of 2010, but in the late fall it went back to being a bullish stock. Since the beginning of May 2011, the stock has been in a sideways channel between about $52 and $56. On Monday TDC closed above its previous high of $56.58. Now that the stock has cleared that hurdle, it doesn’t have anymore resistance in its path.
The theory on this covered call trade is this:
TDC has gotten through resistance and may continue to rise. However, sometimes when a stock gets through resistance it has a tendency to retest the old resistance — which now becomes support — before it goes higher. This covered call can be structured to give this strategy a little more time to work by selling out-of-the-money August calls against the stock position just in case TDC pauses before going higher. This also allows more premium to be collected and gives the stock some downside protection as well. This TDC covered call trade is structured more for maximizing returns on a stock position than for downside protection of the stock.
Covered Call Trade:
Teradata Corp. (NYSE: TDC) – $57.91
Example: Buy 100 shares of TDC @ $57.91 and sell TDC August 60 Call @ $1.85
Cost of the stock: 100 X $57.91 = $5,791 debit
Premium received: 100 X $1.85 = $185 credit
Maximum profit: $394, or $209 (60 – 57.91 X 100) from the stock and $185 from the premium received if TDC finishes at or above $60 @ August expiration.
Breakeven: If TDC finishes at $56.06 (57.91 – 1.85) @ August expiration.
Maximum loss: $5,606 if TDC 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 which in this case is $60. At $60 a share, the stock has moved up the maximum amount with being called away and the sold call expires worthless.
If the stock moves past $60 and looks like it’s not going to slow down, then the call that was previously 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.
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.”