by John Kmiecik | February 14, 2013 8:58 am
Many investors look to own stocks that pay a dividend even though the stock itself might not perform well. But can a stock that hasn’t paid a dividend in years be a good investment? Here’s a trade idea on a business development company that doesn’t pay dividends like its peers, but looks like it still might be a pretty good investment.
The theory on this covered call trade example is this:
American Capital (NASDAQ:ACAS) is a BDC that hasn’t paid a dividend in years. It recently announced earnings and said fourth-quarter income dropped 79%, but adjusted profit beat estimates. In December, American Capital said it had spent more than $100 million to buy back almost 9 million of its shares.
Looking at the chart, shares have moved from just above $8 to $13.70 now. It has slowly climbed higher over the past year, which is an excellent candidate for a covered call. Its current price also makes it somewhat more reasonable from a cost perspective than many covered call candidates. The last time the stock was trading higher levels was back in late 2008, and it really doesn’t have much resistance until it reaches $20.
Example: Buy 100 shares of ACAS @ $13.70 and sell the March 14 call @ 23 cents.
Cost of the stock: 100 x $13.70 = $1,370 debit.
Premium received: 100 x 23 cents = $23 credit.
Maximum profit: $53. That’s $30 ($14 – $13.70 x 100) from the stock and $23 from the premium received if ACAS finishes at or above $14 @ March expiration.
Breakeven: If ACAS finishes at $13.47 ($13.70 – 23 cents) @ March expiration.
Maximum loss: $1,347, which occurs in the unlikely event that ACAS goes to $0 @ March 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 ($14) by March expiration. The stock moves up the maximum amount without being called away, 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 14 strike if the outlook on the stock is neutral or a higher strike if the outlook is still slightly bullish.
Judging from the stock’s past performance, it’s doubtful that it will move much past $14. But considering this is trading and there are risks, you never know. If the stock moves past $14, the 14 strike call option can be bought back and a higher strike with March, or a later expiration 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 if stock moves higher.
If the upward or sideways trend doesn’t continue and 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 didn’t own any securities mentioned here.
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