by John Kmiecik | January 4, 2012 8:45 am
2012 is finally here and it is time to make some resolutions. As an option trader, the first resolution you should make is to trade more covered calls. Otherwise, there’s premium you could be collecting to either help reduce your stock price or give you some extra monthly income that you’re leaving on the table for other investors to scoop up.
Be sure to claim that “extra” money for yourself, because no one deserves it more! I’ll help you get started today. There are plenty of stocks that had a rough third quarter in 2011 and are now trying to make their way back to former levels. Here is a trade idea based on one of those stocks.
United Therapeutics Corp. (NASDAQ:UTHR) is a biotechnology company that develops and sells products to patients with chronic and life-threatening conditions. The company has an excellent balance sheet and has almost $400 million in cash on its books.
Notably, the CEO has been purchasing quite a few shares of company stock since the beginning of December. Many analysts rate this stock as a “Strong Buy.” With all these positives going for it, I’m inclined to agree.
The theory on this covered call trade example is this:
UTHR has had a nice move up since its lows in October. The stock is currently trading at a resistance level right around the $47 area. As is often the case, it might have trouble getting through that area before heading higher.
The next area of resistance is right below $52, where the current 200-day simple moving average resides. With all this overhead resistance, it may be hard for the stock to really go on a bullish run, which makes a covered call a practical trade idea.
Making the UTHR Covered Call Trade
With UTHR trading here at $47.82, you could…
Example: Buy 100 shares of UTHR @ $47.80 and sell the Feb 50 Call @ $1.55
Cost of the stock: 100 X $47.82 = $4,782 debit
Premium received: 100 X $1.55 = $155 credit
Maximum profit: $373 — that’s $218 ($50 – $47.82 X 100) from the stock and $155 from the premium received if UTHR finishes at or above $50 @ February expiration.
Breakeven: If UTHR finishes at $46.27 ($47.82 – $1.55) @ February expiration.
Maximum loss: $4,627, which occurs in the unlikely event that UTHR goes to $0 @ February expiration.
Managing the UTHR 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 at expiration, which in this case is $50. The stock moves up the maximum amount without being called away, gains are enjoyed on the shares and the sold call expires worthless.
In the unlikely event the stock blows past the resistance that is just below $52 and looks like it’s going to go much higher, then the call that was previously sold (UTHR Feb 50 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, it might make sense to close out the entire trade (stock and short call) to avoid further losses.
Need a new year’s resolution for your investing that will pay off in spades? Here’s one to get you started off on the right foot: Do not trade without a designated trading plan this year!
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