by John Kmiecik | August 9, 2012 9:22 am
Sometimes watching a stock can be like watching paint dry: not very exciting. But sometimes boring can be good, especially if a trader is making money. Indeed, many traders will tell you that making money should be rather mundane.
Traders should also have a plan in place to handle every situation before the trade is executed so there won’t be any emotions involved in the decision-making. Here’s a covered call trade idea that has been rather boring to watch — but it’s profitable for those who own the stock.
The theory on this covered call trade example is this:
Ariad Pharmaceuticals (NASDAQ:ARIA) specializes in therapies to help treat patients with the most aggressive forms of cancer. It reported second-quarter earnings last week, and even though it showed a net loss for the quarter, the company estimates that current cash, cash equivalents and marketable securities are sufficient to fund operations to the fourth quarter of 2013.
Ariad recently submitted its leukemia drug Ponatnib to the FDA and hopes to gain approval sometime in early 2013.
The stock has basically increased from just above $8 to where it’s currently trading. Even though the stock has more than doubled its value over the last year, it has done so at a fairly slow and steady pace, which is optimal for a covered call.
Example: Buy 100 shares of ARIA @ $18.86 and sell the September 20 call @ 55 cents.
Cost of the stock: 100 x $18.86 = $1,886 debit
Premium received: 100 x 55 cents = $55 credit
Maximum profit: $169. That’s $114 ($20 – $18.86 x 100) from the stock and $55 from the premium received if ARIA finishes at or above $20 @ September expiration.
Breakeven: If ARIA finishes at $18.31 ($18.86 – 55 cents) @ September expiration.
Maximum loss: $1,831, which occurs in the unlikely event that ARIA goes to $0 @ September 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 $20. The stock moves up to the strike price without being called away, and gains are enjoyed on the shares and the option premium.
Based on ARIA’s performance in the past, it’s unlikely it will move much past the $20 strike. But because this is trading, you can never tell what will happen.
If the stock does look like it will move well over the strike price, there’s a strategy you can implement. 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 the stock moves higher.
This is why it’s advantageous to have a trading plan in place before this trade idea is executed. One part that may be beneficial is to have included in the plan is 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 had no position in any securities mentioned here.
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