Finding a legitimate covered-call candidate in this market isn’t easy. The strategy is generally used to generate additional income for a stock position. An example of this is to buy stock and sell a call option against the stock position.
Generating income from buying and holding stocks has been a challenge, but a good thing about a covered call is that it offers some downside protection as well, and in this market, an investor might just need some. The key is to find a stock with solid fundamentals behind it.
Bed Bath and Beyond (NASDAQ:BBBY) looks like a nice candidate. Its first-quarter earnings were up 38% and had a 10% sales increase.
The stock has had a couple of rough patches in the last couple of years, but it seems like it has always found a way to climb higher. It has been trading in a range between $50 and $60 since the beginning of April. September options can be sold, but they have fewer than 25 days till expiration.
October looks like the better alternative, because it will bring in about twice the premium for the sold call. And just because of the overall market condition lately, this trade is structured more for protecting the stock in case it goes sideways or takes a dip down, but it will still enhance the trade’s return if the stock moves higher.
The Trade: Buy 100 shares of BBBY @ $53 and sell October 55 call @ $2.30
Cost of the stock: 100 x $53.00 = $5,300 debit
Premium received: 100 x $2.30 = $230 credit
Maximum profit: $430 — that’s $200 ($55 – $53 x 100) from the stock and $230 from the premium received if BBBY finishes at or above $55 at October expiration.
Break-even: If BBBY finishes at $50.70 ($53 – $2.30) at October expiration.
Maximum loss: $5,070, if BBBY goes to zero at expiration.
The main goal is for the stock to rise to the sold call’s strike price — $55, in this case. The stock moves up the maximum amount with being called away, and the sold call expires worthless.
As always, if the stock moves past $55 and it looks like it’s not going to slow down, then the call that was previously sold (October 55) can be bought back and a higher strike can be sold against the position. This will allow the stock to remain in the portfolio and also give the position a chance to increase its return. Remember: no matter how far the stock goes beyond $55 at expiration, the maximum profit is capped because of the call that was sold at the 55 strike.
The downside protection on this covered call is set up nicely because there is an area of support (the stock’s 200-day moving average) at about $51, which is just above the break-even point of the trade. If for some reason BBBY takes a dive south, the stock can be sold and the option can be bought back to reduce losses.
Bed Bath & Beyond will announce earnings on Sept. 21.
Every trade should have defined risk and loss parameters in place – even if you’re just “paper trading.”
