6 Option Trades on Big-Name Stocks
12/15/2011 8:00 am EST
The option trading experts at Investorplace.com explain six simple trades that can be executed now on some of today’s most popular blue-chip equities.
As year-end draws closer, investors are hoping jolly Old Saint Nick will remember to load up his sleigh with a nice rally and a shiny bow on top for the world indices. But as the holidays approach, we wouldn’t be surprised if Santa gets spotted in a hammock in Key West, taking a rest from the markets this year because even he just can’t fight the tape.
After all, look at the stories that are set to shape 2012. The recent Euro Summit’s lackluster outcome that only served to doom the currency it was designed to save; Iran closing off a critical waterway for passage of the world’s oil tanker traffic; and more of the same (and that’s nothing much) from the Fed.
Add it all up and it’s easy to see why traders would be happy with a lump of coal: at least energy prices are on the rise!
But there’s no reason for despair. The biggest-name stocks are still standing. They may not be rising—at least, not as fast as we’d like—but that makes this the perfect time to sell call options against them for collecting income, lowering our cost basis, or creating our own capital appreciation.
And so today, our OptionsZone experts have pooled their favorite covered call (or buy-write) trades for you to ensure a happy, healthy, and—best of all—prosperous New Year!
Here are six trades you can make right now without Santa even having to gas up the sleigh to deliver the gains.
Always be sure to check current pricing of the options and underlying before executing any trades.
Trade #1: McDonald’s Corp. (MCD)
Just because a company’s name is globally recognized doesn’t mean that it makes sense to invest in that company. But in this particular instance, it might. Not many companies are recognized around the world more than this one.
It is probably safe to say that McDonald’s (MCD) name is common in most households. Not only does this company market itself effectively, but it has the financial numbers to back it up.
Just recently, the company reported a larger-than-expected rise in same-store sales. Even overseas, same-store sales grew more than expected. If the economy stays the way it has been, the company may continue to benefit because of its relatively inexpensive food options.
The theory on this covered call trade example is this:
- Looking at MCD on a monthly chart over the last nine years, the stock has been slowly rising, setting higher highs and higher lows with only a few exceptions. Just as recently as Monday, shares were at their all-time high just below $99
- The stock might hesitate before going higher because of the imaginary resistance associated with getting above a $100 level for the first time. This should be just a temporary hurdle, if it happens at all for the stock.
MCD Covered Call Trade
With MCD trading here at $98, here’s how you can make option income with your existing shares or by purchasing them now as part of a buy-write strategy (where you buy the stock and sell the call together) that you establish today.
- Example: Buy 100 shares of MCD at $98 and sell one Jan 100 call at $1.25
- Cost of the stock: 100 x $98 = $9,800 debit
- Premium received: 100 x $1.25 = $125 credit
- Maximum profit: $325. That’s $200 ($100 strike – $98 stock price x 100) from the stock and $125 from the premium received if MCD finishes at or above $100 at January expiration
- Breakeven: If MCD finishes at $96.75 ($98 – $1.25) at January expiration
- Maximum loss: $9,675, which occurs in the unlikely event that MCD goes to $0 at January expiration
Managing the MCD 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 at expiration, which in this case is $100. The stock moves up the maximum amount without being called away, gains are enjoyed on the shares, and the sold call expires worthless.
If the stock moves past the $100 barrier and looks like it’s going to go much higher—which is a strong possibility with no resistance overhead—then the call that was previously sold (January 100) 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.
See related: Understanding Options Assignment
The breakeven point ($96.75) on this covered call idea is very close to a support level at around $96.50. If the stock decreases in value, support will likely do its job and keep shares from heading much lower.
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.
Trade # 2: Southern Copper (SCCO)
A market disruption creates opportunities for investors looking for the best stocks on sale. However, volatility can be unnerving regardless of the time frame of your outlook. Combining a covered call and a value stock can help you take advantage of a good investment with a simultaneous hedge and/or income opportunity.
Southern Copper (SCCO) has been growing lately despite the market, and it is a great example of this kind of trade.
The stock is forming an inverted head-and-shoulders pattern (very bullish), and qualifies as a strong fundamental value. Plus, it offers an 8% dividend yield. We expect SCCO to rally strongly when economic fundamentals turn the corner and basic materials stocks start to take off.
We like the current entry opportunity before the breakout below $33 per share. Right now this entry could be combined with a covered call for a “buy-write” order. Selling the SCCO January 32 calls for $1.30 a share can provide a yield of 4% if the stock is not called away. That 4% can also be considered a hedge against volatility over the next month if the stock dips a little.
Reselling a new option each month could really amplify your annual performance while you wait for the market to turn around. Don’t worry if the stock gets called out at $32 per share, because based on current prices (around $29), that would create a nice profit in a little over a month.
You can then take your profits off the table and buy back in when the stock dips a little. Not a bad way to “manage” a valuable stock while the market sorts itself out.
Trade # 3: Walgreen Co. (WAG)
Recommended by Serge Berger, The Steady Trader
The covered call is a mildly bullish strategy. The reason it is only mildly bullish is that the profit potential of the position to the upside is limited by the short call, but the covered call can also partially offset a decline in the stock price (although the payoff diagram looks just like that of a short put).
Walgreen (WAG) is a consumer cyclical stock. As such, by definition, in a slowing economy, that might mean it isn’t well-positioned to bloom exceedingly. But since the covered call works best on range-bound to slowly uptrending issues, this is the right strategy at the right time for WAG.
Looking at the daily chart of WAG, we note that since late September, the stock has roughly traded in a range between $31.50 and $35.50. Its three-month at-the-money calls have a volatility of around 43.90.
This puts Walgreen in the top 15 stocks in the S&P 100 in terms of implied volatility. As a seller of calls, you will prefer to have somewhat elevated volatility in order to get more premium.
The stock has resistance near the $35.50 mark, but has the potential to break out above there. However, given the macroeconomic environment, it is not very likely the stock shoots much above the $36 mark in the near term.
As of this writing, the stock trades at $33.70. A trader wanting to open a covered call on WAG could consider selling the April 36 calls for $1.60.
Above $36 (at expiration), the stock would get called away and the trader is protected down to just about $32.
Below $32, the stock may accelerate lower, so that would be a natural stop-loss area. The covered call investor would lose less than had he only bought the underlying shares.
Trade # 4: Google (GOOG)
Recommended by Stutland Volatility Group
After the wild ride the news took the market on in 2011, many may give up trying to predict 2012. While what next year holds for politics and the economy is anyone’s guess, we are certain of one thing: The world’s access to the Internet will continue to grow at a staggering rate.
And what name comes to mind first when thinking about the World Wide Web and all its offerings? Google (GOOG). In fact, it is such an ingrained part of our life that “Googling” is synonymous with searching the Web.
In 2012, the analyst consensus is for earnings to grow by 20%. That’s because even with dismally low consumer confidence, Internet ad spending—Google’s bread and butter—is on the rise.
In the first half of 2011, $15 billion was spent on Internet ads, up 25% from 2010. Google has been able to capitalize on this growth by taking market share from competitors like Apple (AAPL), Millennial Media, Yahoo! (YHOO), and Microsoft (MSFT).
Typically, growth like this is accompanied by a high P/E multiple, but Google is trading at only 16 times forward earnings. Because of this, we see Google as a great value stock with the potential for explosive growth.
However, we do not simply want to buy the stock here—not yet, anyway—but rather use the market’s current volatility to our advantage by selling the GOOG March 555 puts.
Yes, this is a bit of a departure from our covered-call theme. But these puts trade at a 33% implied volatility and are over 10% out of the money, which could present a good level to enter a long position in the stock.
By selling these puts, we are agreeing to buy the stock at $555 should Google be trading there or lower at March expiration. Google at $555 would be a tremendous value and we would happily be buyers there. Then we would turn around and sell calls against them at the at-the-money or just slightly out-of-the-money strike!
If Google is above $555 at expiration, then we keep the put’s juicy $13.50 premium and book a solid profit in the first quarter of 2012.
Here’s a closer look at how to construct this Google trade.
- Option play: Short put
- Sell: March 555 put at $13.50
- Net cost: $13.50 (credit)
- Breakeven: $541.50 (short strike - net credit)
- Max profit: $13.50 (net credit)
- Max loss: $541.50 (short strike - net credit)
Trade # 5: Marathon Oil (MRO)
Recommended by Tyler Craig, Tyler’s Trading
Though the covered call appears to be a simple strategy, there are actually a number of ways in which traders go about selecting the right candidate.
Some take the more aggressive route and buy cheaper, more volatile stocks that boast high potential returns for covered call sales. Others look to stable dividend payers that provide a more conservative approach but smaller potential returns.
Perhaps the best approach is to strike the right balance between the two. That is, find a stock that appears stable, yet still offers options with high enough premiums to make the covered call trade worthwhile.
Marathon Oil (MRO) is one stock in the energy space offering a compelling set-up. From a charting standpoint, it has recovered quite nicely from its October lows and has stabilized above its rising 50-day moving average.
Traders could buy the stock around $28.30 and sell the MRO Jan 29 calls for $1.06 or better. The maximum potential profit if MRO resides above $29 at January expiration comes out to a 6.5% return.
Trade # 6: Ross Stores (ROST)
Recommended by John Kmiecik, MarketTaker.com
It looks like nothing is getting resolved in this European debt and banking crisis. The market seems to be fluctuating up and down every other day. In the United States, the experts say the economy is starting to get better. But who knows who to truly believe?
When in doubt, investors and traders may seek out fundamentally solid companies that offer discount goods or services to add to their portfolio that may flourish in tough economic times. Ross Stores (ROST) looks like it might make a covered call trader happy.
ROST operates over 1,000 discount retail stores in the United States and Guam. The company’s after-tax margin on a year-ago basis has risen for 11 straight quarters. Many analysts rate this stock as a “buy.”
For the last month, ROST had a nice move up from lows of about $84 and has traded mostly sideways, never getting above $94 throughout December.
Just as recently as Monday, shares were at an all-time high of just over $95 as the stock is attempting to break out of its sideways channel. This volatile market may keep the stock from just heading straight up.
ROST Covered Call Trade
With ROST trading here at $92.90, here’s how you can establish a covered-call strategy right now:
- Example: Buy 100 shares of ROST at $92.90 and sell one January 95 call at $1.80
- Cost of the stock: 100 x $92.90 = $9,290 debit
- Premium received: 100 x $1.80 = $180 credit
- Maximum profit: $390. That’s $210 ($95 - $92.90 x 100) from the stock and $180 from the premium received if ROST finishes at or above $95 at January expiration
- Breakeven: If ROST finishes at $91.10 ($92.90 - $1.80) at January expiration
- Maximum loss: $9,110, which occurs in the unlikely event that ROST goes to $0 at January expiration
Managing the ROST 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 $95. The stock moves up the maximum amount without being called away and the sold call expires worthless.
If the stock moves past $95 and looks like it’s going to go much higher—which is a strong possibility with no resistance overhead—then the call that was previously sold (Jan 95 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 for whatever reason, it might make sense to close out the entire trade (stock and short call) to avoid further losses.
By Investorplace.com contributors