Nothing is more exciting than discovering a new company that might be ready to benefit from advances in technology and upgrading its product line. But what if that new company is actually one that has been around for awhile and is well known?
Here’s a stock that might look good for a covered call if the company continues to evolve and the stock continues its uptrend.
The theory on this covered call trade example is this:
Last month eBay (NASDAQ:EBAY) reported second-quarter results that included a 23% rise in sales and a 16% rise in profits. Despite a slowdown overseas, the company was able to grow. Many consider this growth results from eBay making several improvements to its site, including making it more user-friendly.
Plus, the company just recently announced that its PayPal unit is teaming up with Discover Financial Services to allow PayPal users to pay with their account where Discover cards are accepted.
If that wasn’t good news enough, the stock has performed solidly over the last six months, climbing about $10 in that time. eBay is probably not going to run away very fast anytime soon, but it should be able to keep intact this slow trend of moving higher. The stock has some resistance right below $48 from a previous high set way back at the end of 2005 that may keep it in check for a little while.
EBAY — $47
Example: Buy 100 shares of eBay @ $47 and sell the September 48 call @ 1.
Cost of the stock: 100 x 47 = $4,700 debit
Premium received: 100 x 1 = $100 credit
Maximum profit: $200. That’s $100 ($48 – $47 x 100) from the stock and $100 from the premium received if eBAY finishes at or above $48 @ September expiration.
Breakeven: If eBay finishes at $46 ($47 – $1) @ September expiration.
Maximum loss: $4,600, which occurs in the unlikely event that eBay goes to $0 @ September expiration.
Trade Management
The best-case scenario for a covered call strategy is for the stock to rise just up to the sold call’s strike price at expiration, which in this case is $48. 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 EBAY’s performance over the last six months and resistance around the strike price, it’s unlikely that eBay will move much past the $48 strike. Considering this market has been moving higher despite analysts expectations of a correction, a trader will want to have a plan in place just in case.
If the stock does look like it will move well over the strike price, another strategy 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.
As addressed above, it’s advantageous to have a trading plan in place before this trade idea is executed. Here’s another thing that may be good to include in the plan: 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 security mentioned here.
