Kevin Matras explains how to implement a Covered Call option strategy. Stocks in this week’s article are American Public Education, Inc. (NASDAQ: APEI), Greenhill & Co., Inc. (NYSE: GHL), The Children’s Place RetailStores, Inc. (NASDAQ: PLCE), Myriad Genetics, Inc. (NASDAQ: MYGN) and Wabtec Corp. (NYSE: WAB). Click here for the full story exclusively on Zacks.com: http://at.zacks.com/?id=109
Screen of the Week written by Kevin Matras of Zacks Investment Research:
Today, I want to go over Covered Call Writing. This is an excellent strategy to use in up, down and sideways markets. This is a strategy used to reduce risk and generate income.
Options
Buying an option gives you the right, but not the obligation, to purchase 100 shares of a stock at a certain price within a certain period of time.
The price you pay, let's say $500, is the premium. In general, if the stock goes up, the option will increase in value. If the stock goes down, it'll decrease in value. But your risk is limited to what you paid for the option. Even if the stock went to zero, you could never be on the hook for more than you paid.
If you write an option, you're collecting that premium. Someone else is buying the right to own 100 shares of a stock at a certain price within a certain period of time. If that stock goes down and the option expires worthless, the buyer of the option loses $500. But the writer of the option, makes $500.
This is who we're going to be -- the writer.
Now, let's say you have 100 shares of AAPL stock at $110, for example. For every dollar AAPL goes up or down, your investment will increase or decrease by $100.
Now let's say you wrote the November $125 calls at $6.50 – you stand to collect $650.
Here's what this means:
Example 1: If Apple stock goes down $6.50 to $103.50 between the time you wrote the option and its expiration, you've just offset $6.50 or $650 worth of your downside risk. Because if AAPL went down $6.50, your stock position just declined by $650. But, at option expiration, you've gained $650 – essentially losing nothing even though AAPL declined $6.50.
Example 2: Now let's say AAPL stays flat. It doesn't go up or down. It just stays at $110. You haven't made anything or lost anything on that stock. But at expiration, that $125 call option you wrote for $650 would expire and be paid to you. So even though the stock didn’t budge, you still made $6.50 or $650.
Example 3: Now let's say AAPL goes up instead. It rallies all the way up to $125. That's even better. You've just made $15 on your stock or $1,500. And at expiration, that $125 call you wrote will expire worthless and you'll pocket $650. Your grand total is now a $21.50 gain or $2,150 on a $15 move.
Example 4: Lastly, if the stock rallies past $125 – let's say $131.50 for example. You're now giving up some of your profit potential. If it went from $110 to $131.50, that's a $21.50 move or $2,150 gain. However, at expiration, that $125 call is now $6.50 in the money, which means that option is actually worth $650. That would go against your gains.
As the option writer, you are obligated to deliver that stock at $125, even though it's at $131.50. Now most people don't get their stock called away from them. Usually they'll simply buy that option back before it expires. If that's what happens, you'll have to pay $6.50 to get out of that position, and that'll reduce your total profit by $650, meaning you've now only made $1,500.
Essentially, when you write an option, you're reducing your downside by a set amount, but you're also potentially giving up some upside, which is the difference between the price of the stock and the option you wrote.
Sometimes this will happen. Although, you can simply 'roll' your option up by buying back the original strike price and writing one further out, thus opening up your profit opportunity. You can even buy a call, giving you upside potential as well.
But stocks won't always go straight up. And while sometimes you may lose out on some upside potential, you'll likely find yourself consistently collecting premiums on your covered calls over and over again.
You can implement this strategy on stocks you currently own. Or you can screen for new ones and begin this strategy with new stocks.
A screen I'm running today is very simple:
* Options Exist equal to 1 (yes)
* Zacks Ranks less than or equal to 2
* Price greater than or equal to $30
* Avg. Daily Volume greater than 100,000
* EPS Revisions, F1 & F2 greater than 0 (I want to see this year's and next year's estimates being revised higher)
* Market Value greater than $800 ($800 million) (I generally prefer to look for mid-cap and large cap companies for my covered write strategies)
I will then look at the charts and maybe even do some additional qualitative analysis on them by looking at the Zacks Equity Research reports.
Here are a few stocks that came thru this week's screen for 10/14/08:
| APEI | American Public Education | |
| GHL | Greenhill & Co. | |
| PLCE | Children's Place Retail | |
| MYGN | Myriad Genetics, Inc. | |
| WAB | Wabtec Corp. |
Note: After the huge sell-off in the markets over the previous 2 weeks, we're seeing nice rebounds in the majority of stocks. This rebound will soon slow and many stocks will begin to trade off of their valuations and fundamentals as opposed to the emotionally driven price swings of late. Once the rebound slows, that would be an excellent time to start initiating a Covered Call strategy.
To begin your own search for the best optionable stocks for your Covered Call strategy, sign up for your 2-week FREE trial to the Research Wizard. Remember the key to successful screening is in discovering those screens that have produced profitable results in the past. And that's exactly what you get with the powerful Screening and Backtesting ability of Research Wizard. Learn how, today: http://at.zacks.com/?id=111
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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