Trade #5 – Walgreen
Recommended by Serge Berger, The Steady Trader
The covered call is a mildly bullish strategy. The reason it is only mildly bullish is that the profit potential of the position to the upside is limited by the short call. But the covered call can also partially offset a decline in the stock price (although the payoff diagram looks just like that of a short put).
Walgreen (NYSE:WAG) is a consumer cyclical stock. As such, by definition, in a slowing economy that might mean it isn’t well-positioned to bloom exceedingly. But since the covered call works best on rangebound-to-slowly uptrending issues, this is the right strategy at the right time for WAG.
Looking at the daily chart of WAG, we note that since late September, the stock has roughly traded in a range between $31.50 and $35.50. Its three-month at-the-money calls have a volatility of around 43.90.
This puts Walgreen in the top 15 stocks in the S&P 100 in terms of implied volatility. As a seller of calls, you will prefer to have somewhat elevated volatility in order to get more premium.
The stock has resistance near the $35.50 mark but has the potential to break out above there. However, given the macroeconomic environment, it is not very likely the stock shoots much above the $36 mark in the near term.
As of this writing, the stock trades at $33.70. A trader wanting to open a covered call on WAG could consider selling the April 36 Calls for $1.60.
Above $36 (at expiration) the stock would get called away and the trader is protected down to just about $32. Below $32 the stock may accelerate lower, so that would be a natural stop-loss area. The covered call investor would lose less than had he only bought the shares.
Trade #6 – Ross Stores
Recommended by John Kmiecik, MarketTaker.com
It looks like nothing is getting resolved in this European debt and banking crisis. The market seems to be fluctuating up and down every other day.
In the United States, the experts say the economy is starting to get better. But who knows who to truly believe?
When in doubt, investors and traders may seek out fundamentally solid companies that offer discount goods or services to add to their portfolio that may flourish in tough economic times.
Ross Stores (NASDAQ:ROST) looks like it might make a covered-call trader happy. ROST operates over 1,000 discount retail stores in the United States and Guam.
The company’s after-tax margin on a year-ago basis has risen for 11 straight quarters. Many analysts rate this stock as a “Buy.”
For the last month, ROST had a nice move up from lows of about $84 and has traded mostly sideways, never getting above $94 throughout December.
Just as recently as Monday, shares were at an all-time high of just over $95 as the stock is attempting to break out of its sideways channel. This volatile market may keep the stock from just heading straight up.
Making the ROST Covered Call Trade
With ROST trading here at $92.90, here’s how you can establish a covered-call strategy right now.
Example: Buy 100 shares of ROST @ $92.90 and sell 1 Jan 95 Call @ $1.80
Cost of the stock: 100 X $92.90 = $9,290 debit
Premium received: 100 X $1.80 = $180 credit
Maximum profit: $390 — that’s $210 ($95 – $92.90 X 100) from the stock and $180 from the premium received if ROST finishes at or above $95 @ January expiration.
Breakeven: If ROST finishes at $91.10 ($92.90 – $1.80) @ January expiration.
Maximum loss: $9,110, which occurs in the unlikely event that ROST goes to $0 @ January expiration.
Managing the ROST Covered Call Trade
The main objective for a covered call strategy is for the stock to just rise up to the sold call’s strike price, which in this case is $95. The stock moves up the maximum amount without being called away and the sold call expires worthless.
If the stock moves past $95 and looks like it’s going to go much higher — which is a strong possibility with no resistance overhead — then the call that was previously sold (Jan 95 Call) can be bought back and a higher strike can be sold against the position to avoid assignment. This will allow the stock to remain in the portfolio and also give the position a chance to increase its return.
If the stock drops in price more than was anticipated for whatever reason, it might make sense to close out the entire trade (stock and short call) to avoid further losses.