When looking at stock charts for potential covered-call candidates, traders and investors are typically looking for a stock that is slowly rising. The reason is so that gains can be realized not only from the option premium but also from the stock itself.
In a perfect trading world, the stock would continue to rise over the life of the strategy. Nothing is a given in options trading, but when selling covered calls, it helps to start with a stock that has been slowly rising for some time. A steady uptrend can mean the stock may be able to withstand a few bearish punches the market could land in the future.
One momentum name that caught our eye was El Paso Corp. (NYSE:EP), which owns North America’s largest natural gas pipeline and is one of North America’s largest independent natural gas producers. It provides natural gas and energy-related products and is headquartered in Houston, Texas. The company has multiple fundamental strengths such as increasing net income, revenue growth and rising profit margins.
Every quarter, many money managers have to disclose stocks they have bought and sold. One of the biggest hedge funds, Eton Park, just recently increased its share of EP stock. This move may not make the stock rise anymore but it’s nice to be on the same side of at least one professional hedge fund trader. As the saying goes, “great minds think alike!”
On a technical basis, the stock has been continually hitting a 52-week high as the stock has slowly moved higher. In fact, EP shares are up about 13% since the beginning of the year. If the stock continues its slow climb, this covered call idea should be able to give your portfolio some energy.
The Trade Idea – Covered Call
Buy 100 shares of EP stock for $29.76. Simultaneously short the May 31-strike call for a credit of 25 cents per contract. The stock purchase results in a net debit of $2,976, which is offset by the sold call credit for a total debit of $2,951.
The maximum profit is $149, which is $124 from the stock (should EP rise from its current price up to the sold strike price) plus the $25 credit from selling the call. Profit is maximized if EP is trading at or above $31 at May options expiration.
The maximum loss is $2,951, which occurs in the rare event that EP drops all the way to zero before May options expire. Breakeven for this trade is $29.51; the covered call strategy is profitable at May expiration if EP shares are trading at or above this level.
Trade Management
The main objective for a covered call is for the stock to just rise up to the sold call’s strike price at expiration, which in this case is $31. In this scenario, the stock moves up the maximum amount without being called away, gains are enjoyed on the shares, and the sold call expires worthless (allowing the call seller to keep 100% of the initial credit).
In the unlikely event EP breaks its pattern of slowly rising and turns very bullish, there is a strategy a trader or investor can implement. If the new outlook for the stock is much higher than $31, the call option can be bought back and a higher strike can be sold against the position to avoid assignment. This allows 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 the entire trade (stock and short call) to rein in further losses.
As of this writing, John Kmiecik does not own any shares mentioned here.
