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Free Covered Call Trade

Free covered call recommendation on Alkermes is a stock and call setup for income investment.

CALL STRATEGY:

Look at the November 16 covered call. For each 100 shares of Alkermes (ALKS) stock you buy, sell one November 16 covered call option for a 14.78 (16.13 – 1.35) debit or better. That’s potentially a 8.3% assigned return on investment.

 The technicals for ALKS are bearish with a weak downward trend. The stock is under accumulation with support at 15.70. S&P rates this stock 4 STARS (out of five) – buy.
 S&P maintains Buy opinion on shares of Alkermes (ALKS). ALKS completes its acquisition of Elan Drug Technologies for $1.02B, consisting of $500M in cash and issuance of 31.9M of its shares. We continue to see the deal significantly diversifying revenues with royalties from products with long patent lives, thus lowering its risk profile. We also see robust cash flows supporting a rapidly advancing R&D pipeline. On anticipated earnings accretion, we raise our adjusted FY 12 (Mar.) EPS estimate $0.47 to $0.08 and FY 13’s by $0.79 to $1.02. We keep our target price at $22, which reflects the expected benefits from the deal.
Check out the Get Rich Monthly Income Plan for more investment income strategies.

Adding a Put to a Covered Call

When you buy a put for a covered call trade, you then have both a sold call and bought put on the stock you own.  This is called a “collar” as you have a
protective put on a covered call.  The classic collar has an at-the-money (ATM) call and put at the same strike price.  In the case of the covered call trader, the
bought put serves as additional downsize protection against a stock price decline.

When you add a put to a covered call trade, you are adding additional cost to the trade.  This will increase your cost basis for the trade. However, you can create a totally riskless covered call trade.  Let’s look at an example using Tiffany (TIF).

TIF is trading at $74.77 in the market.  You can sell the 75 Call for $4.20 and buy the 75 Put for $4.00.  If the stock is above 75 at closing, if will be called away and you gain $0.43 in profits (75-74.77+.20).  Additionally, we could sell the put if there is any value left before expiration.  In this scenario, you make money from the covered call side.

If TIF is trading below 75 at expiration, the call will expire worthless but the put will have value.  You would exercise the 75 put which will give you $75.00 for the stock shares trading below the 75 strike price.  You would then make a profit of $0.43 on the protective put side of the trade.

Tiffany (TIF) Stock
Stock Price         74.77
Sell 75 Call           4.20
Buy 75 Put           4.00
Net Premium           0.20
Net Cost         74.57
Downside Risk                –
Max Profit           0.43

 

This trade is a risk-free trade because the total cost basis ($74.57) is below both strike prices of 75.  Regardless of what happens to the stock price, you will receive $75.00 for your stock. You can say that this collar trade is an arbitrage trade because there was a positive difference between the call and put prices at the 75 strike price.  The return of $0.43 is only a 0.58% return.  When you add trading commissions to the cost basis, this can’t be arbitraged by a retail investor.  For more active traders, you can vary your timing of closing the call and put sides to increase your profit.  For example, when the sold call loses the majority of value, you can close this side by buying to close the call.  Then, you will own the stock with the put guarentee at the strike price.  There are numerous possibilities when you actively managed the collar trade if you make adjustments before expiration.

You can construct a similar trade with different strike prices for the call and put.  When you vary the strike prices this, you are changing the cost basis and risk exposure.  For example with the 75 covered call on TIF, we might buy the 72.5 put for $3.15 (see table below).  This will give us a max profit of $1.05 and
downsize risk of $1.22.

Tiffany (TIF) Stock
Stock Price         74.77
Sell 75 Call           4.20
Buy 72.5 Put           3.15
Net Premium           1.05
Net Cost         73.72
Downside Risk           1.22
Max Profit           1.05

 

The great part about this type of trade is that you are limiting the amount of downsize by using the blanket put.  If the stock market bottom falls out with a
10% correction, you will only lose $1.22 per covered call or 1.65%.

Free Covered Call Trade on Novartis

Covered Call Recommendation on Novartis
Call Strategy: Look at the January 55 covered call. For each 100 shares of Novartis AG (NVS) stock you buy, sell one January 55 covered call option for a 51.62 (55.77 – 4.15) debit or better. That’s potentially a 6.5% assigned return.

 The technicals for NVS are bearish with a weak downward trend. The stock is under accumulation with support at 54.77. S&P rates this stock 4 STARS (out of five) – buy.

S&P research notes:

 S&P reiterates buy opinion on ADSs of Novartis AG (NVS) . NVS recently updated investors on its long-term strategy, indicating that group level margins will be enhanced by its Alcon and Vaccines & Diagnostics (V&D) units, alleviating the impact of patent losses on key brands such as Diovan, Femara and Zometa.
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How To Use a Protective Put with a Covered Call

One of the basic mistakes that new covered call traders make is that they trade for the highest premium available to maximize their monthly income without looking at the amount of risk they are taking on with this type of trade.  When option premiums are high there is a reason for the increase in option pricing because of some uncertainty or increased risks.  The advanced covered call trader knows this and uses a protective put to manage their risk of loss on a high volatility trade.

The classic strategy is protect a position is to buy a put which is referred to as a “protective put.”  With a put buy you have the right (but no obligation) to sell a stock at the strike price of the put.  The protective put allows the stock owner to keep the stock but limits the amount of downsize to a lower stock price at the put’s strike price.  The stock owner no longer has price risk once the stock price falls below the put strike price as they can sell the stock at the put strike price before the option expires.
Stock investors refer to a put as price insurance as the cost of buying a put is similar to paying an insurance premium and the ownership of the put is
the insurance policy.  The management of stock price insurance is an additional cost to the trade.  For covered call investors, they must determine if it is worthwhile to buy the put as it will affect their monthly income plan.  The amount of buying a put depends on the amount of time before expiration, the strike price and the implied volatility of the put.  As you know, as volatility increases then option prices will tend to increase as well.

The table below shows an example trade with Under Armour (UA).  The stock is trading at $67.74 per share.  This example displays buying a put for protection at three strike prices: ITM, ATM & OTM.  As shown, the more in-the-money (ITM) the put then the more protection in stock price and less risk exposure in dollar terms.  The risk exposure is calculated by subtracting the put strike price from the net debit (share price + put cost).

The bottom two rows in the table show selling an ATM October call of 67.5 on UA.  You will receive $5.80 in premium for every call sold.  If you subtract this call premium from the risk exposure shown in the top portion of the table, you get the total risk exposure of the covered call with protective put trade.

Again – the more ITM the trade, the less risk exposure.  This example assumes the protective put strike price comes into play.  Of course, you would not usually use this strategy in a bull market as it is more effective during bear markets with increased levels of uncertainty.  You can also play what-if by using different
expiration months for the protective put.

How to use a protective put with a covered call

Click to enlarge

 

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