by John Kmiecik | July 26, 2012 9:04 am
Let’s be honest. It’s not easy finding great covered call candidates in this volatile market. Generally, stocks that are slightly bullish-to-neutral make suitable candidates for this strategy. Good luck finding stocks that have options available in that type of trend.
Here is a possible candidate that has come down in price where investors might feel that it is a buying opportunity.
The theory on this covered call trade example is this:
Verizon Communications (NYSE:VZ) delivers broadband and other wireless services to consumer and business customers. The company recently released its second-quarter earnings and fared pretty well. Revenues grew by only 3.7% for the second quarter, but the company grew more than 12% overall because of a reduction in the cost of services and sales and a reduction in interest expense. The key will be to see if they can maintain this.
The stock has been trending higher since early April and recently has dropped in price partly because of the overall market, in all probability. VZ now is at a previous resistance area around $44, which will hopefully act as support for the stock. If investors think this is a good area to buy, the stock might be able to trend higher once again in the future.
Example: Buy 100 shares of VZ @ $43.72 and sell the August 44 call @ 50 cents.
Cost of the stock: 100 X 43.72 = $4,372 debit.
Premium received: 100 X 0.50 = $50 credit.
Maximum profit: $78 — that’s $28 (44 – 43.72 X 100) from the stock and $50 from the premium received if VZ finishes at or above $44 @ August expiration.
Breakeven: If VZ finishes at $43.22 (43.72 – 0.50) @ August expiration.
Maximum loss: $4,322, which occurs in the unlikely event that VZ goes to $0 @ August expiration.
The best-case scenario 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 $44. This covered call trade idea is basically counting on VZ to trade sideways until about August expiration because of unsettled market conditions. The stock can move higher by about 28 cents without being called away and gains are enjoyed on the shares and the option premium.
If VZ rises faster than anticipated and past the $44 strike price, there is a strategy that can be implemented. The call option 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 stock moves higher.
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.
As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities.
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