Just when you thought there may be calmer times ahead, the uncertainty has returned.
Because of this, the covered-call options strategy plays such an invaluable role in longer-term stock investments. This means buying or already owning a stock and selling a call option against the position. A covered call is generally used to generate additional income for a stock position. Another benefit of a covered call is that it is like purchasing the stock at a discount rate because of the credit received from the short call. If the stock falls in price, the short call in essence lowers the break-even point on the trade.
Let’s see what looks good this week:
Watson Pharmaceuticals (NYSE:WPI) develops branded and generic drugs, including oral contraceptives and smoking cessations aids. Analysts see the company’s EPS rising 30% this year and 27% next year.
The stock has been on a steady climb up since the end of 2008. When the market had its downturn at the end of July, the stock fell as well. Since that drop, however WPI has risen again, and it’s approaching a resistance level at around $70. The October 70 call looks like the option to sell because of that resistance.
The Trade: Buy 100 shares of WPI at $67.50 and sell October 70 call at $1.70
Cost of the stock: 100 x $67.50 = $6,750 debit
Premium received: 100 x $1.70 = $170 credit
Maximum profit: $420 — that’s $250 ($70 – $67.50 x 100) from the stock and $170 from the premium received if WPI finishes at or above $70 at October expiration.
Break-even: If WPI finishes at $65.80 ($67.50 – $1.70) at October expiration.
Maximum loss: $6,580, if WPI goes to $0 at expiration.
The main objective for any covered call strategy is for the stock to rise up to the sold call’s strike price — in this case $70, the stock’s resistance level. The stock moves up the maximum amount with being called away and the sold call expires worthless.
Remember: No matter how far the stock goes beyond $70 at expiration, the maximum profit is capped because of the call that was sold at the 70 strike.
If WPI does go sideways or drops in price from where the trade was entered, selling the call option has lowered the cost of the stock by $1.70 a share. The trade now has a lower break-even point.
The company is expected to announce earnings on Oct. 26.
Every trade should have defined risk and loss parameters in place even if the trader or investor is just “paper trading.”
