A Covered Call for You Athletic Types

07/22/2011 7:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Using Lululemon Athletica (LULU) as an example, see how a covered call option strategy allows the trader to profit from an upside move while staying protected in the event of sideways or downward trading.

Deciding whether or not to open a covered call position in this type of choppy market can be a challenge for some traders and investors. The general thought on the covered call is to find a stock that is stagnant but overall slightly bullish.

What is great about a covered call is that it offers some downside protection just in case the market really turns bearish.

The stock on the radar today is Lululemon Athletica Inc. (LULU). Lululemon designs, manufactures, and distributes athletic apparel and accessories in North America and Australia. LULU has had a nice run for the last two years, and in addition, the stock just split less than two weeks ago.

For most of July, the stock has been channeling sideways, possibly due to the overall market indecision. The split has lowered the price of the stock and has made it more desirable from a portfolio perspective.

The theory on this covered call trade example is this:

LULU has exceptionally strong fundamentals. Earnings per share (EPS) is expected to rise 39% and the company plans on opening 25 more stores this year. The stock recently hit its all-time high. The only worry now is what the market will do…which is always a concern.

August or September calls can be used for this strategy. September will give the trade a longer time to rise and provide some additional premium because of the longer expiration for some downside protection.

This LULU covered call trade is structured more for protecting the stock in case it goes sideways or takes a dip down, but will enhance the trade’s return if the stock never does.

Lululemon Athletica Inc. (LULU): $64.00 at time of writing (be sure to check current price)

Covered Call Example

Buy 100 shares of LULU at $64.00 and sell LULU September $67.50 call at $3.30

Cost of the stock: 100 x $64.00 = $6,400 debit

Premium received: 100 x $3.30 = $330 credit

Maximum profit: $680; that’s $350 ($67.50 – $64.00 x 100) from a gain on the stock and $330 from the premium received if LULU finishes at or above $67.50 at September expiration.

Breakeven: If LULU finishes at $60.70 ($64.00 – $3.30) at September expiration.

Maximum loss: $6,070 if LULU goes to $0 at expiration.

The goal for any covered call strategy is for the stock to rise up to the sold call’s strike price, which in this case is $67.50. The stock moves up the maximum amount without being called away and the sold call expires worthless.

As always, if the stock moves past $67.50 and looks like it’s not going to slow down, then the September $67.50 call can be bought back and a higher strike can be sold against the position. This will allow the stock to remain in the portfolio and also give the position a chance to increase its return.

If LULU for some reason takes a dive south, the stock can be sold and the option can be bought back to reduce losses.

The company has no scheduled earnings announcements at this point.

Remember, every trade should have defined risk and loss parameters in place even if the trader or investor is just paper trading.

By Dan Passarelli of MarketTaker.com

Dan Passarelli writes the Market Taker Edge options newsletter. Dan has more than 17 years’ experience in the options industry as a market maker, options instructor, author of Trading Option Greeks, and as a Traders Expo speaker.

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