by Dan Passarelli | August 18, 2011 10:55 am
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.
Source URL: http://investorplace.com/2011/08/try-a-covered-call-to-profit-from-carbo-ceramics-bounceback/
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