Playing PetSmart As It Moves Up

by John Kmiecik | October 11, 2012 9:15 am

It always feels good to be part of a group. Whether it’s being on a sport team or having a membership in a club, it’s good to be part of something and hopefully feel wanted. Take this covered call idea. This stock was part of something, but just recently it joined an even more elite group. Could this help its performance even more?

This trade idea is counting on it, and it might just turn out to be a trader’s best friend. The theory on this covered call trade example is this:

PetSmart (NASDAQ:PETM[1]) was moved from the MidCap 400 to the S&P 500 earlier this month. Now that the stock is part of an elite group, it needs to perform like it belongs there. In general, PetSmart is well regarded by most analysts, who have it ranked as a buy or a hold. The company continues to grow at an impressive rate, which was reflected in its last earnings announcement in August. PetSmart posted net income growth of 28%, and management increased the company’s future guidance.

The stock has generally been trading in a range between $64 and $72 for the last four months. If we look at a longer trend, the stock has been on a steady climb higher for more than two years. If it can break that resistance area around $72, there’s no telling how far PETM can climb. The November 75 strike was chosen to give this stock some time to rise, especially in these shaky markets.

PETM$70.17

Example: Buy 100 shares of PETM @ $70.17 and sell the November 75 call @ 70 cents.

Cost of the stock: 100 x $70.17 = $7,017 debit.

Premium received: 100 x 70 cents = $70 credit.

Maximum profit: $553. That’s $483 ($75 – $70.17 x 100) from the stock and $70 from the premium received if PETM finishes at or above $75 @ November expiration.

Breakeven: If PETM finishes at $69.47 ($70.17 70 cents) @ November expiration.

Maximum loss: $6,947, which occurs in the unlikely event that PETM goes to $0 @ November expiration.

Trade Management

The best-case scenario for this covered call strategy is for the stock to rise just to the sold call’s strike price at November expiration, which in this case is $75. 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 bullishness ensues and PETM rises faster than anticipated and past the $75 strike before November expiration, 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 your 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 had no position in any security mentioned here.

Endnotes:
  1. PETM: http://studio-5.financialcontent.com/investplace/quote?Symbol=PETM

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