We all know the expression “I wouldn’t have believed it if I hadn’t see it with my own two eyes.” The saying is most appropriate lately for the banking sector. It was nearly left for dead over a year ago, but now it has come roaring back. Here’s a covered call trade idea on one particular bank that might be able to profit if the momentum higher continues.
The theory on this covered call trade example is this:
Citigroup (NYSE:C) is one of biggest banking names out there. This giant has been riding a wave higher, partly due to the housing market slowly rising again. It could be a great relief for banks if housing prices continue to climb. Many investors are looking forward to the Federal Reserve’s bank stress tests in March, but many analysts have already predicted that banks should be able to easily pass — and have the potential to keep growing.
Click to EnlargeTechnically, the stock has moved from around $25 to where it’s currently trading since the beginning of June 2012. Just yesterday, C was able to strongly close at $39.45 — over a resistance level around $38.50 (previous highs) that it failed to move above for more than nine months.
The next pivot high that could act as resistance for the stock will come in the $43 area, which gives the stock considerable room to keep climbing. It may pull back some before moving higher again after the extended run it went on. Here’s how this trade idea works:
Example: Buy 100 shares of C @ $39.45 and sell the January 41 call @ 83 cents.
Cost of the stock: 100 x $39.45 = $3,945 debit.
Premium received: 100 x 83 cents = $83 credit.
Maximum profit: $238. That’s $155 ($41 – $39.45 x 100) from the stock and $83 from the premium received if C finishes at or above $41 @ January expiration.
Breakeven: If C finishes at $38.62 ($39.45 – 83 cents) @ January expiration.
Maximum loss: $3,862, which occurs in the unlikely event that C goes to $0 @ January expiration.
The maximum profit potential for this covered call strategy is for the stock to rise just up to the sold call’s strike price ($41) by January expiration. The stock moves up the maximum amount without being called away because of the short strike, and profits are enjoyed on the shares and the option premium.
The process can be duplicated for the next expiration if so desired, using either the same $41 strike if the outlook on the stock is neutral or a higher strike if the outlook and the stock continues to be bullish.
If C fails to pullback or keeps on climbing higher and passes the $41 level well before expiration, you can make an adjustment. The $41 strike 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, especially C moves higher.
The breakeven point of the trade ($38.62) is very close to the area of support that was previous resistance. This area might be able to help keep C from moving lower if the stock falters.
If stock drops in price more than was anticipated or below the breakeven point, 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 didn’t own any securities mentioned here.