Covered calls can be a great investment strategy. The hard part about any option approach is picking the right stock to complement the strategy. Generally, a trader looks for a stock that is slightly bullish. The goal of a covered call is to collect a premium from the sold call and profit from the stock gaining value, too.
Here’s a possible covered call trade idea that might just beautify your portfolio like a fresh coat of paint.
The theory on this covered call trade example is this:
Sherwin-Williams (NYSE:SHW) recently hit a new 52-week high and looks like it’s wanting more. SHW develops, manufactures and distributes paints and coatings to professional, industrial, commercial and retail customers. Just last week Credit Suisse analysts wrote, “We continue to believe SHW is one of the better names in the chemicals/materials space and should enjoy solid earnings growth as the housing markets recover.”
The stock itself has been in a slow and steady uptrend with a few pullbacks since September 2011. If you’re looking for a slightly bullish stock, SHW fits the bill. It’s currently setting those all-time highs with no resistance overhead. How high can Sherwin-Williams go? Only time will tell.
SHW — $121.54
- Example: Buy 100 shares of SHW @ $121.54 and sell the June 125 call @ $1.55
- Cost of the stock: 100 x $121.54 = $12,154 debit
- Premium received: 100 x $1.55 = $155 credit
- Maximum profit: $501; that’s $346 ($125 – $121.54 x 100) from the stock and $155 from the premium received if SHW finishes at or above $125 @ June expiration.
- Breakeven: If SHW finishes at $119.99 ($121.54 – $1.55) @ June expiration.
- Maximum loss: $11,999 which occurs in the unlikely event that SHW goes to $0 @ June expiration.
The main objective 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 $125. 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 event SHW breaks its pattern of slowly rising and becomes very bullish, a trader or investor can implement another strategy. If the new outlook for the stock is much higher than $125, the call option can be bought back, and a higher strike can be sold against the position to avoid assignment. Considering there are over 40 days until expiration, this is a possibility. This move 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 possibly avoid further losses.
Remember: Always have a trading plan in place before entering any trade even on a simulated platform.