by John Kmiecik | July 19, 2012 8:46 am
With all this talk about the latest diet drugs being approved recently, pharmaceuticals have been in the news even more than normal. Many traders and investors are told to stay away from drugmakers because they are simply too volatile, but that might not always have to be the case. Here is a covered call trade idea on a pharmaceutical company that might just cure your portfolio’s ailments.
The theory on this covered call trade example is this:
Abbott Laboratories (NYSE:ABT) is one of the biggest and most well-known pharmaceutical companies. The company just reported earnings and beat the consensus estimate for profits. Revenue rose 2% on the strength of its arthritis drug Humira. The company is on the process of splitting into two companies and still is on schedule to have this completed by the end of the year.
From a technical perspective, the stock has been in a solid uptrend for the better part of a year. In fact, shares have gained about 25% over the last year. What also is nice about ABT is that it has no overhead resistance to slow it down because the stock is trading at all-time highs. Fundamentally and technically, there should be nothing to keep ABT from moving higher.
Example: Buy 100 shares of ABT @ $65.93 and sell the August 67.5 call @ 40 cents.
Cost of the stock: 100 X 65.93 = $6,593 debit.
Premium received: 100 X 0.40 = $40 credit.
Maximum profit: $197 — that’s $157 (67.50 – 65.93 X 100) from the stock and $40 from the premium received if ABT finishes at or above $67.50 @ August expiration.
Breakeven: If ABT finishes at $65.53 (65.93 – 0.40) @ August expiration.
Maximum loss: $6,553, which occurs in the unlikely event that ABT goes to $0 @ August expiration.
The objective for each expiration on 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 $67.50. The stock moves up the maximum amount without being called away, and gains are enjoyed on the shares and the option premium. Then the process can be duplicated for the next expiration if so desired.
If ABT rises faster than anticipated, an adjustment 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 avoid further losses.
As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities.
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