by John Kmiecik | February 7, 2013 8:33 am
You’ve probably heard the saying that slow and steady wins the race. The same can be true of a covered call. Here’s a trade idea on a stock that looks more like the tortoise than the hare — which is perfect for this strategy.
The theory on this covered call trade example is this:
Mylan (NASDAQ:MYL) is a generic-drug producer that has been on the move. The Food & Drug Administration approved its Abbreviated New Drug Applications (ANDAs) for generics of hypertension treatments, and sales of its EpiPen have increased due to the increasing prevalence of allergies, especially among children. The company also plans to spend about $15 million on advertising.
Click to EnlargeThe stock just recently hit an all-time high and shows no current signs of slowing down. Shares have been slowly moving higher since late October of 2012, and with no overhead resistance to possibly trim MYL’s rise, who knows how high it might climb.
Example: Buy 100 shares of MYL @ $28.81 and sell the March 30 call @ 31 cents.
Cost of the stock: 100 x 28.81 = $2,881 debit.
Premium received: 100 x 31 cents = $31 credit.
Maximum profit: $150. That’s $119 ($30 – $28.81 x 100) from the stock and $31 from the premium received if MYL finishes at or above $30 @ March expiration.
Breakeven: If MYL finishes at $28.50 ($28.81 – 31 cents) @ March expiration.
Maximum loss: $2,850, which occurs in the unlikely event that MYL 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 ($30) by March expiration next month. 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 $30 strike if the outlook on the stock is neutral, or a higher strike if the outlook continues to be slightly bullish.
With Mylan’s current slow trend in place, it’s doubtful the stock will move much past $30. If earnings (which will likely be reported on Feb. 18.) or something else causes it to rise, the $30 strike call option can be bought back, and a higher strike with a March or later expiration 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, especially if MYL moves higher.
If the upward trend doesn’t continue and the stock drops in price more than 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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