Covered calls are generally viewed as a conservative strategy of professional investors and traders. Once a few of the concepts are clear, however, individual investors and traders can benefit as well.
As Thursday’s early session has shown, the market has been extremely choppy — and mostly bearish — over the last month or so. The market had delivered a nice run-up to recover some of the losses, but the general tone of the market is still predominately bearish. Obviously, nobody is certain what will happen, and that is why a covered call is so nice — it offers some downside protection, especially for stocks of companies with strong fundamentals.
The stock we are concentrating on is Carbo Ceramics (NYSE:CRR). It has gone from about $40 all the way up to $180 in less than two years. Toward the end of July, the stock has dropped $60 with the downturn in the market and has recovered almost half of that in the last two weeks (Shares are down to $140 on Thursday amid the broad selloff).
The stock might be a little expensive for some, but the company is especially sound fundamentally.
Here’s how a covered-call trade would work:
A couple of weeks ago, the company announced quarterly revenue was up 34% and raised its dividend for the 11th consecutive year. The worry is that the market will once again be bearish and drag the stock down with it.
Of course, on a somewhat neutral or bullish strategy, that is always a concern. September expiration has just fewer than 30 days until the options expire. This CRR covered-call trade is structured more for downside protection on the stock position, but it still gives the position a chance to increase its return in this turbulent market.
The trade, as of Wednesday’s closing price:
Buy 100 shares of CRR @ $146, and sell the September 150 call @ $6.80
Cost of the stock: 100 x $146 = $14,600 debit
Premium received: 100 x $6.80 = $680 credit
Maximum profit: $1,080 — that’s $400 ($150 – $146 x 100) from the stock and $680 from the premium received if CRR finishes at or above $150 at its September expiration.
Break-even: If CRR finishes at $139.20 ($146 – $6.80) at September expiration.
Maximum loss: $13,920, if CRR goes to zero at its September 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 $150. The stock moves up the maximum amount without being called away and the sold call expires worthless.
As always, if the stock moves past $150 and looks like it’s not going to slow down, then the call that was previously sold (the Sept 150) 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. If the market plummets and/or CRR declines severely, the stock can be sold and the option can be bought back to reduce losses.
Every trade should have defined risk and loss parameters in place.