Being a smart and prudent trader in this environment is extremely crucial. A strategy that may look good today can look less desirable the next day. Finding a suitable candidate for a covered call options strategy in this market may take a little more time to research.
A covered call means buying (or already owning) a stock and selling a call option on the same stock. Generally, the strategy generates additional income for a stock position, but another benefit is that it’s like purchasing the stock at a discount. The credit received from the call sales offsets some of the purchase price of the stock. The credit also lowers the break-even point of the trade, which is especially beneficial if the stock drops in price.
Lorillard (NYSE:LO) makes cigarettes that are mainly sold in the U.S. and Puerto Rico. The company has a nice financial position with manageable debt levels and has an impressive record of earnings per share growth and increases in net income.
The stock has been trading basically sideways since mid-June, staying below $115. If the stock continues to trade sideways below $115, the November 115 calls will expire worthless and produce some income. With just over two weeks left until October expiration, selling the November 115 call provides a greater premium than the October 115 call, because more time is priced into the option. A longer expiration and the 115 strike will give the stock extra time to profit from going higher too.
The Trade: Buy 100 shares of LO at $112 and sell November 115 call at $5
Cost of the stock: 100 x $112 = $11,200 debit
Premium received: 100 x $5 = $500 credit
Maximum profit: $800 — that’s $300 ($115 – $112 x 100) from the stock and $500 from the premium received if LO finishes at or above $115 at November expiration.
Break-even: If LO finishes at $107 ($112 – $5) at November expiration.
Maximum loss: $10,700, which occurs in the unlikely event that LO goes to zero expiration.
The ideal goal is for the stock to just rise up to the sold call’s strike price, $115 in this case. The stock moves up the maximum amount without being called away, gains are enjoyed on the shares and the sold call expires worthless.
If the stock moves past $115 and looks like it’s going to go much higher, then the call that was previously sold (November 115) can be bought back and a higher strike 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.
If the stock drops in price more than was anticipated, it might make sense to close out the entire trade (stock and short call) to avoid further losses.
The company is expected to announce earnings on Oct. 24.
