Try This Healthy Tobacco Trade

by John Kmiecik | August 2, 2012 8:57 am

Try This Healthy Tobacco Trade

Sometimes bad habits can be profitable. Take, for example, a producer of tobacco products. It generally is regarded that smoking tobacco products is not beneficial for your health, and in fact can be dangerous. But still, people continue to smoke.

Trading also can be considered dangerous to your health — depending on how a trader handles the stress and anxiety that trading is sometimes known to cause.

Here is a trade idea that benefits from a bad habit and may just provide some stress relief from another. The theory on this covered call trade example is this:

Altria Group (NYSE:MO[1]) primarily produces tobacco products. Marlboro and Parliament are a couple of their more famous brands. The company just reported solid earnings last week, including a 9%-plus increase of adjusted earnings per share[2]. What really was astounding was that MO was able to increase revenues despite a declining cigarette volume. Analysts have forecast that the company’s EPS will grow about 6% a year for the next five years.

Technically, a trader could almost not ask for a better six-month chart for a covered call. The stock has been slowly rising with a few minor pullbacks for better than six months. The stock never has been higher before, so there is no overhead resistance that might stall it from continuing to climb. Is it too good to be true? We’ll have to wait and see.

MO$36.03

Example: Buy 100 shares of MO @ $36.03 and sell the September 37 call @ 23 cents.
Cost of the stock: 100 X 36.03 = $3,603 debit.
Premium received: 100 X .23 = $23 credit.
Maximum profit: $120 — that’s $97 (37 – 36.03 X 100) from the stock and $23 from the premium received if MO finishes at or above $37 @ September expiration.
Breakeven: If MO finishes at $35.80 (36.03 – 0.23) @ September expiration.
Maximum loss: $3,580, which occurs in the unlikely event that MO goes to $0 @ September expiration.

Trade Management

The ultimate profit 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 $37. The stock moves up to the strike price without being called away, and gains are enjoyed on the shares and the option premium.

Since there are about 50 days until expiration, there is a chance that MO can rise faster than anticipated and past the $37 strike price. If that happens, 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.

Endnotes:
  1. MO: http://studio-5.financialcontent.com/investplace/quote?Symbol=MO
  2. 9%-plus increase of adjusted earnings per share: http://investorplace.com/2012/07/altria-beats-earnings-revenue-forecasts/

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