Make This Chocolatey Covered Call

by John Kmiecik | June 21, 2012 9:24 am

Many things in life get sweeter over time. Maybe a love, an appreciation of something … or a portfolio increasing its net worth. There probably is nothing sweeter than finding a stock that has the potential to increase its value over time, and applying the correct strategy to take advantage of it. Here is a covered call trade idea that might be sweet for your portfolio — and also sweet for your dentist.

The theory on this covered call trade example is this:

The Hershey Co. (NYSE:HSY[1]) manufactures markets and sells chocolate and other confectionery products. The company has a P/E ratio of close to 24, which is well above the S&P 500 P/E ratio of 17.7. Hershey has had solid revenue growth, expanding profit margins and good cash flow from operations. In other words, HSY after all these years still is capitalizing on people’s love of chocolate[2].

The stock has been in a decent uptrend for the better part of a year, with the month of June being an exceptional one for HSY. The stock has moved from around $66 to above $70, where it is currently trading. Being that the stock might be a bit extended, August was chosen for the expiration month to sell in case the stock does pull back before trying to head higher (it might not). Plus, there was not much premium to be collected for selling July 75 call options.

HSY: $70.63

Example: Buy 100 shares of HSY @ $70.63 and sell the August 75 call @ 35 cents
Cost of the stock: 100 X 70.63 = $7,063 debit
Premium received: 100 X 0.35 = $35 credit
Maximum profit: $472: That’s $437 (75 – 70.63 X 100) from the stock and $35 from the premium received if HSY finishes at or above $75 @ August expiration.
Breakeven: If HSY finishes at $70.28 (70.63 – 0.35) @ August expiration.
Maximum loss: $7,028, which occurs in the unlikely event that HSY goes to $0 @ August expiration.

Trade Management

The main objective for a covered call strategy is for the stock to just rise up to the sold call’s strike price at expiration, which in this case is $75. The stock moves up the maximum amount without being called away, gains are enjoyed on the shares and the sold call expires worthless.

In the event HSY continues its climb higher, there is a strategy a trader or investor can implement. The call option can be bought back and a higher strike can be sold against the position to avoid assignment. Considering there are almost 60 days until expiration, this is a possibility. This month alone the stock has increased more than $4 a share. 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 possibly avoid further losses.

Nothing is sweeter than a profitable trade!

As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities.

  1. HSY:
  2. still is capitalizing on people’s love of chocolate:

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