The new year is upon us, and so are many new and exciting trading options and strategies. But a few things about trading never change from year to year. For example, a solid trend to follow never goes out of style, and a reliable income-generating strategy never gets old. Here’s a trade idea that combines both.
The theory on this covered call trade example is this:
Alaska Air Group (NYSE:ALK) provides passenger air travel along the West Coast, Canada and Mexico. Revenue growth has been relatively impressive, and ALK has increased its earnings per share about 22% over the last year. Cash flows are also growing at a steady rate.
Click to EnlargeLooking at Alaska Air’s chart, you notice that since the beginning of August 2012, the stock has gained around $10 at a slow and steady pace. An ideal stock candidate for a covered call is one that’s slowly increasing, just like ALK. It fell in price at the very end of December, but looks to be heading higher again as 2013 kicks off. A recent pivot high was just around $45, which makes it the perfect strike to sell.
ALK — $43.94
Example: Buy 100 shares of ALK @ $43.94 and sell the February 45 call @ $1.05.
Cost of the stock: 100 x $43.94 = $4,394 debit.
Premium received: 100 x $1.05 = $105 credit.
Maximum profit: $211 that’s $106 ($45 – $43.94 x 100) from the stock and $105 from the premium received if ALK finishes at or above $45 @ February expiration.
Breakeven: If ALK finishes at $42.89 ($43.94 – $1.05) @ February expiration.
Maximum loss: $4,289, which occurs in the unlikely event that ALK goes to $0 @ February 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 ($45) by February expiration. In that case, 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 45 strike if the outlook on the stock is neutral or a higher strike if the outlook and the stock continue to be bullish.
Since expiration is more than 40 days out, there’s a chance that this bullish stock moves past the strike price well before expiration. If that happens, an adjustment can be made: The 45 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 gives your position a chance to increase its return, especially if stock moves higher.
The breakeven point ($42.89) on this covered call is situated close to a pivot low ($43.63), which can act as support and keep the stock from moving lower in case of a decline. If the stock drops in price more than was anticipated and below the pivot low, 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.