Now that the market has recouped some of its losses over the last couple of months, it might be easier to find potential covered-call candidates. The strategy is to buy a stock (or already own the stock) and sell a call option against the stock position. A covered call is generally used to generate additional income for a stock position.
Another benefit of a covered call is that it’s like buying the stock at a discount because of the credit received from the short call.
Royal Gold (NASDAQ:RGLD) looks like a splendid candidate. The company owns and manages interests in precious metals in 14 countries. The company just had its best quarter since the beginning of 2008 and looks to hopefully improve on that next quarter.
RGLD has been a steady performer over the last several months with gold prices rising. Over the last week and a half, the stock has risen about $10. With the market attempting to rally, gold prices might just take a breather from going higher, which, in turn, might cause gold companies like RGLD to take a breather — or go sideways — as well.
If that’s the case, selling the call will generate some income if the stock doesn’t rise.
The Trade: Buy 100 shares of RGLD at $75.70 and sell October 80 call at $2.75
Cost of the stock: 100 x $76.70 = $7,670 debit
Premium received: 100 x $2.75 = $275 credit
Maximum profit: $605 — that’s $330 ($80 – $76.70 x 100) from the stock and $275 from the premium received if RGLD finishes at or above $80 at October expiration.
Break-even: If RGLD finishes at $73.95 ($76.70 – $2.75) at October expiration.
Maximum loss: $7,395 if RGLD goes to $0 @ expiration.
The main objective for a covered-call strategy is for the stock to rise up to the sold call’s strike price, which in this case, is $80. The stock moves up the maximum amount with being called away, and the sold call expires worthless.
If RGLD just zooms past $80 and looks like it’s not going to slow down, then the call that was previously sold (October 80) can be bought back and a higher strike can be sold to start the covered-call strategy again. 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 much the stock goes above $80 at expiration, the maximum profit is capped because of the call that was sold at the 80 strike.
If RGLD does go sideways or drops in price from where the trade was entered, selling the call option in essence lowered the cost of the stock by $2.75 a share. The trade now has a lower break-even point.
Every trade should have defined risk and loss parameters in place even if the trader or investor is just “paper trading.”
