Earnings season is upon us, so traders and investors need to be careful when picking stocks to buy and, in turn, to sell calls against for income. A bad report can cause the stock to drop more in value than anticipated.
But what if the stock just had a favorable announcement? This might set up a scenario where the stock may continue to slowly rise or at least not become bearish – excellent conditions for entering a covered call position.
A quick explanation of the covered call strategy is when a trader buys stock (or already owns shares) and, at the same time, sells a call as part of the same trade. Generally, covered calls generate additional income for a stock position – the market pays you just for owning them!
The universal approach for finding good covered call candidates is to identify a stock that is stagnant but, overall, slightly bullish. This week, it’s equally important to find a candidate whose earnings have already hit the tape, so that there are no short-term surprises in store.
With that in mind, EMC Corp. (NYSE:EMC) looks like a viable candidate this week. The company just reported earnings on Tuesday morning. This provider of corporate data-storage systems reported that its third quarter net income rose 28%. Earnings were 37 cents a share, which was a penny ahead of most analysts’ estimates.
In keeping with our guidelines for selecting the right stocks for our covered call strategy, the company has a positive year-end outlook.
The stock has been trading basically sideways between $20 and $23 since the beginning of August. After the earnings announcement, the stock gapped over the $23 resistance area, triggering a possible bullish move to the upside.
The $23 area should now act as support for the stock. The way the erratic market has been trading, a conservative estimate for the stock is about $25 for November expiration, which is just below the horizontal 200-day moving average.
Making the EMC Covered Call Trade
Here’s how you can make this trade for instant income generation:
With EMC currently trading at $24…
Example: Buy 100 shares of EMC @ $24 and sell the Nov 25 Call @ $0.44
Cost of the stock: 100 X $24 = $2,400 debit
Premium received: 100 X $0.44 = $44 credit
Maximum profit: $144 — that’s $100 ($25 stock target – $24 current price X 100) from the stock and $44 from the option premium received if EMC finishes at or above $25 @ November expiration.
Breakeven: If EMC finishes at $23.56 ($24 – $0.44) @ November expiration.
Maximum loss: $2,356, which occurs in the unlikely event that EMC goes to $0 @ November expiration.
Managing the EMC Covered Call Trade
The main objective for a covered call strategy is for the stock to just rise up to the sold call’s strike price, which in this case is $25. The stock moves up the maximum amount without being called away, gains are enjoyed on the shares and the sold call expires worthless.
Because of a solid earnings report, EMC has a chance to go above $25 way before November expiration. If the stock looks like it’s going to go much higher, then the call that was previously sold (the Nov 25 Call) 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 the stock drops in price more than was anticipated, it might make sense to close out the entire trade (stock and short call) to avoid further losses.
A great trader, like a great sailor, is not made sailing smooth seas!
