by Bryan Perry | December 16, 2013 9:54 am
It’s always a surprise to income investors when I tell them that options trading unequivocally has a place in their portfolios. While long-term buy-and-hold investing for tax advantages is the core tenet of my income strategy in Cash Machine, short-term covered calls are also an invaluable tactic that I benefit from in my Cash Machine Trader service. And covered calls are safe enough they’re approved for use in virtually any individual retirement account.
Short-term (or “spot month”) covered calls are a great way to conservatively play bullish names that are set for a quick spike. Now, they may not be names that meet my requirement of double-digit dividend yields, but if I expect a stock to jump 6% to 12% in a few weeks’ time, that’s when I like to buy the shares and sell to open (or write) a covered call against it.
Names like Brocade Communications Systems (BRCD), Bank of America (BAC), Ford (F) and Twenty-First Century Fox (FOX) are all stocks that I like with a short-term bullish picture, but their paltry dividends mean I wouldn’t recommend holding them long-term for income. But using covered calls is a great way to create “synthetic dividends” in these names.
Let me illustrate how this works with a short-term covered call you can take advantage of today in a name that’s remained high on investors’ watch lists: Groupon (GRPN).
Shares of the online coupon provider should benefit from the bump in holiday gift-giving, and the chart shows a constructive double-bottom is forming. While GRPN stock is currently trading around $10.25, which is a great place to get long, it should make another stab at $11, if not higher. We can augment that gain by going after some call option premium.
Provided your broker has given you the most basic level of permission, you can use a covered call order to simultaneously buy shares of GRPN and sell call options against those shares. The two transactions occur at the same time when using a covered call order. While you need to check with your broker, most investors already have permission to execute covered calls, but on the off chance that you don’t, getting authorization should only require a quick call to your broker.
From there, using a covered call order is easy with one caveat: You must buy at least 100 shares of a stock to be able to sell a covered call against it because a call option corresponds to 100 shares of the underlying stock, in this case GRPN.
Recommendation: For every 100 shares of GRPN that you buy at market, sell to open one GRPN Jan. $11 Call option at 30 cents or more.
When you use a covered call order, the cost of the stock shares will be debited from your account as usual, but when you sell to open the call option, that 30-cent option premium will immediately be deposited in your account. This is where you get paid to trade!
So, what do you have gain from this GRPN covered call? A quick and easy 10% in about a month’s time with very little risk to you.
Here’s how: If you buy GRPN shares at $10.25 but also collect a 30-cent premium from the calls, your cost basis is essentially $9.95 per share. On Jan. 18, 2014, when the GRPN Jan $11 Calls expire, I expect GRPN shares to be trading at or above $11.00. This means our shares will be “called away” from us at the call option’s $11 strike price for that 10%-plus gain.
The first question I get is, “Why don’t you simply just buy the shares of GRPN and sell them when they’re up?”
It’s a fair question with an easy answer: Covered calls mitigate risk. We’ve all been party to the whipsaw in this market and using a covered call may cap your upside, but it also limits your downside. If for some reason GRPN isn’t trading at or about $11 come Jan. 18, that’s OK – we’ll simply hold the shares and write another covered call against them to collect even more premium. But my expectation is that this market will gain strength as the year closes and GRPN should sail up to $11.
I encourage you to dip your toe into the calm covered call waters with this GRPN recommendation. Once you begin using covered calls, you”ll realize the potential they have to help you boost returns for your long-term holdings, as well as how they can help you bring in short-term gains with very little risk. Join me now at Cash Machine Trader, and I’ll show you exactly how to start.
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