by John Kmiecik | March 15, 2012 11:15 am
It seems like everything these days is done over some type of computer. From banking, to shopping, and let’s not forget trading. The world is becoming completely dependent on computers for every aspect of life.
With that thought in mind, how can one paper company be doing so well right now? One reason International Paper (NYSE:IP) is thriving in an increasingly paperless world is that it is well diversified (just like an investor’s portfolio should be). In fact, it looks like a strong candidate for a covered-call strategy.
IP is a global leader in the paper and packaging industry and commands a wide range of products from paper, consumer packaging and even wax and wax alternatives. The Memphis, TN-based company is generally liked by analysts and the company has solid fundamentals, especially its return on equity. What’s more, IP recently announced it is considering raising its dividend and/or buying back shares for the first time since the recession.
The stock has been in a pronounced uptrend since the beginning of October 2011. IP hasn’t always been able to produce a higher pivot high in that time but has been able create a higher pivot low. Until that trend is broken, it looks like it has the momentum to keep moving higher. On Wednesday, the stock was at its 52-week high and for this covered call trade idea to really profit, it needs to keep moving in that same direction.
Example: Buy 100 shares of IP for $35.60 and sell the April 37-strike call for a credit of 50 cents or better. The cost of the stock is $3,560 while the premium received is $50, for a total net debit of $3,510.
The maximum profit is $190, or $140 (37 – 35.60 * 100) from the stock and $50 from the premium received. Profit is maximized if IP is trading at or above $37 at April expiration. The maximum loss is $3,510, which occurs in the unlikely event that IP has fallen all the way to $0 in the next month before April expiration.
The covered-call strategy will break even if IP is trading above $35.10 when the options expire. This is the stock price at the time of purchase less the credit collected for selling the call.
The best-case scenario and maximum profit potential for a covered call is for the stock to just rise up to the sold call’s strike price at expiration, which in this case is $37. In this case, the shares move up the maximum amount without being called away. Gains are enjoyed on the stock and the call expires worthless, allowing the seller to keep the premium.
In the event IP moves past the $37 area early in the trade and it looks like it will go much higher, then the call that was previously sold (April 37) can be bought back and a higher strike can be sold against the position to avoid assignment. This allows the stock to remain in the portfolio and also give the position a chance to increase its return. This scenario isn’t out of the question if IP continues to set 52-week highs.
If the stock drops in price more than anticipated, it probably makes sense to close out the entire trade (stock and short call) to possibly avoid further losses. Plan your trade and trade your plan!
As of this writing, John Kmiecik does not own any shares mentioned here.
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