by John Kmiecik | September 27, 2012 8:47 am
It seems like the market is just a little confused. It has had a nice bullish run through summer, and now many analysts believe it will have at least a small correction, which it has already started. Many stocks appear to be doing the same.
Here is a covered call trade idea that might be able to take advantage of a stock’s correction — and make you think about getting something to eat while waiting to profit.
The theory on this covered call trade example is this:
Brinker International (NYSE:EAT) owns, operates and franchises various restaurants mostly in the United States. It also operates restaurants under the Chili’s Grill and Bar and Maggiano’s Little Italy brand names. The company has impressive revenue growth and a solid return on equity, and the stock has performed impressively over the last year. In fact, EAT has gapped higher after the last couple of earnings announcements.
What’s happening now to Brinker is what is happening to most stocks — it is pulling back. This might continue for a little bit longer if the bears have their way. What’s nice about this covered call is that the breakeven point of the trade is close to an area of support ($34) that should be able to keep the stock from declining much further.
Example: Buy 100 shares of EAT @ $34.65 and sell the October 35 call @ 60 cents.
Cost of the stock: 100 X 34.65 = $3,465 debit.
Premium received: 100 X .60 = $60 credit.
Maximum profit: $95 — that’s $35 (35 – 34.65 X 100) from the stock and $60 from the premium received if EAT finishes at or above $35 @ October expiration.
Breakeven: If EAT finishes at $34.05 (34.65 – 0.60) @ October expiration.
Maximum loss: $3,405, which occurs in the unlikely event that EAT goes to $0 @ October expiration.
The objective on 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 $35. The stock moves up the maximum amount without being called away and gains are enjoyed on the shares and the option premium. Then the process can be duplicated for the next expiration if so desired.
The 35 strike was chosen based on an outlook of a neutral to slightly bearish market. If EAT rises faster than anticipated and past the $35 strike long before October expiration, there is an adjustment that can be implemented. The call option 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 stock moves higher.
If Brinker International 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.
As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities.
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