Buy Hewlett and Sell a Call Against it

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This article is from Mike Scanlin, CEO of Born To Sell, a site providing insight and trading ideas on selling covered call options.

A weak macro environment and poor company news often brings overselling of an otherwise good stock. The good news is this can create a “buy the dip” opportunity for option trading investors.

That is what has happened to Hewlett-Packard (NYSE: HPQ) this week. Yes, it missed numbers and gave weak guidance. But it’s a solid company and the overall nasty market has exaggerated the dip. Now is the time when a short-term buy-write (covered call) has good odds of doing well, as most of the people who wanted to sell have already sold.

HPQ Stock Price Last 6 Months (Aug 25, 2010, to Feb 24, 2011)

Hewlett-Packard

Hewlett-Packard Stock

The positive is that when you buy a dip like this you can sell an in-the-money covered call to give yourself additional downside protection and collect time premium. HPQ’s next earnings aren’t until May, so the March and April option cycles are not subject to earnings releases. There is an 8 cent dividend that goes ex-dividend on March 14, so both March and April option cycles will collect that dividend.

We have three ways to buy this dip with a buy-write strategy depending on your risk level.

For the more conservative 1%/month club (12% or more annualized return):

Month Strike Net Debit Days to Expiration Annualized Return if Flat
Mar 40 39.67 23 14.3%
Apr 40 39.26 51 14.3%

For the semi-aggressive 2%/month club (24% or more annualized return):

Month Strike Net Debit Days to Expiration Annualized Return in Flat
Mar 41 40.44 23 23.8%
Apr 42 40.54 51 26.5%

For the risk-loving 3%/month club (36% or more annualized return):

Month Strike Net Debit Days to Expiration Annualized Return if Flat
Mar 42 41.07 23 38.1%

In each case the Net Debit is your cost to put on the buy-write investment (cost to purchase the stock minus the premium you receive for selling the call option). It is also your break even point for the trade (if HPQ finishes above your Net Debit on option expiration day then you have a profit).

If you owned HPQ before the recent dip then you probably do not want to sell one of these in-the-money options, as you would be locking in the loss from the dip. In those cases you may want to wait for the stock to rebound a bit, or sell some near-term (March) out of the money calls so you can get a little income while you wait.

There is another, more aggressive strategy called “legging in” where you buy the stock first and then wait until it has risen a point or two before selling an in-the-money covered call. Not a bad strategy but it definitely has more risk (and potential reward) than just doing a buy-write right out of the gate.

Dip buying is not for everyone. But when you combine it with in the money covered calls on solid companies you reduce the risk and could collect some nice premium.

Mike Scanlin operates Born To Sell, a web site dedicated to helping people earn monthly income from selling call options.


Article printed from InvestorPlace Media, https://investorplace.com/2011/02/buy-hewlett-and-sell-a-call-against-it/.

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