The market seems to have woken up after the Easter break. Volatility looks to be back. Now may be a crucial time for investors to give their equities a little downside protection. Here is a covered call trade idea on a stock that has been moving higher for the past couple of months and might continue to do so even if the market turns a little bearish.
Mattel (NYSE:MAT) is the world’s largest toy company. The stock pays a 3.5% dividend yield on a 35% earnings payout. Mattel has almost doubled its dividend over the past five years; over the past year, the stock’s P/E ratio has gone from 15 to about 18 times.
Click to EnlargeMAT traded in a range between $34 and $38 from August 2012 to February 2013. Since the beginning of February, the stock has moved higher and continually set new 52-week highs. The stock’s all-time high is just about $3 away from where it is now — which makes that level a great target for the stock.
Selling some calls against the stock until it gets there might make some sense, especially in this unpredictable market. Here’s how to do it:
- Buy 100 shares of MAT at $42.99 and sell the May 45 call at $0.40
- Cost of the stock: 100 x $42.99 = $4,299 debit
- Premium received: 100 x $0.40 = $40 credit
- Maximum profit: $241 — that’s $201 ((45 – 42.99) x 100) from the stock and $40 from the premium received — if MAT finishes at or above $45 at May expiration.
- Breakeven: If MAT finishes at $42.59 ($42.99 – $0.40) at May expiration.
- Maximum loss is $4,259, which occurs in the unlikely event that MAT goes to $0 @ May expiration.
The best-case scenario for this covered call strategy is for the stock to just rise up to the sold call’s strike price ($45) at May 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, using either the same 45 strike if the outlook on the stock is neutral, or a higher strike (maybe 46 or 47 based on the all-time high) if the stock looks like it wants to head higher.
Since there are more than 40 days until May expiration, MAT may try to move past $45 well ahead of expiration. There’s an adjustment you can make in that case. The 45 strike call option can be bought back and a higher strike with May (or later) expiration can be sold against the position to avoid assignment. These options have $1 strike increments, so traders have multiple strikes to choose from. This adjustment will allow the stock to remain in the portfolio and also gives the position a chance to increase its return — especially if stock moves higher.
The breakeven point ($42.79) of the trade is just below a previous pivot low of $42.99. This area may act as support for the stock to keep it from falling. Every trader needs to determine for himself when to cut their losses if the stock drops in price, but the breakeven point of the trade or the stock’s support area should be considered. It probably makes sense to close out the entire trade (stock and short call) to possibly avoid further losses.
At the time of publication, Kmiecik had no positions in the securities mentioned.
