Buy the Dip in Hewlett-Packard with Options

02/28/2011 12:40 pm EST

Focus: OPTIONS

Tech giant Hewlett-Packard sold off following bad earnings and investor jitters, but the company and its stock are strong. Here’s how to use covered call options to profit.

The combination of a lousy macro environment and bad company-specific news can lead to overselling of an otherwise good stock. After all, when the stock market is diving lower and investors feel like they need to lighten up on their exposure, many will typically sell the thing that just announced some bad news, creating a "buy-the-dip" opportunity for others.

That is what has happened to Hewlett-Packard (HPQ) in the last few trading days. Yes, they missed numbers and gave weak guidance, but it's a solid company and the overall nasty market has exaggerated the dip. It's times like this when a short-term, buy-write (covered call) has good odds of doing well, because most of the people who wanted to sell have already sold.

Related: See “Two PC Giants: Time to Buy?” for more on HPQ’s recent earnings

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The good news is that if you're going to buy the dip like this, you can sell an in-the-money covered call to give yourself additional downside protection and collect time premium.

HPQ's next earnings aren't until May, so the March and April option cycles are not subject to earnings releases. There is an eight-cent dividend that goes ex-dividend on March 14, so both March and April option cycles will collect that dividend.

We have three ways to buy this dip with a buy-write strategy depending on your risk level.

For the more conservative investor, 1%/month club (12% or more annualized return):

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For the semi-aggressive investor, 2%/month club (24% or more annualized return):

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And for the risk lovers, 3%/month club (36% or more annualized return):

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In each case, the net debit is your cost to put on the buy-write investment (cost to purchase the stock minus the premium you receive for selling the call option). It is also your breakeven point for the trade (if HPQ finishes above your net debit on options expiration day, then you have a profit).

If you owned HPQ before the recent dip, then you probably do not want to sell one of these in-the-money options because you would be locking in the loss from the dip. In those cases, you may want to wait for the stock to rebound a bit, or sell some near-term (March), out-of-the-money calls so you can get a little income while you wait.

There is another, more aggressive strategy called "legging in" where you buy the stock first and then wait until it has risen a point or two before selling an in-the-money covered call. Not a bad strategy, but it definitely has more risk (and potential reward) than just doing a buy-write right out of the gate.

Dip buying is not for everyone, but when you combine it with in-the-money covered calls on solid companies, you can reduce the risk and collect some nice premium.

By Mike Scanlin of BornToSell.com

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