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November, 2018:

Covered Calls: How Do They Work?

Last time we talked about what kind of strategies we can take in a sideways market, and here’s one good option, the covered call.

WHAT IS A COVERED CALL?

One of your rights as a stock owner is the right to sell your stock at any time for the current market price. The selling of this right to someone else in exchange for cash paid today is called “covered call writing”. What this means is that you give the option buyer the right to purchase your shares prior to the expiration date of the option at a predetermined price, known as the “strike price”.

The “call option” is a contract agreement giving the buyer of that option a legal right, without obligation, to buy a set number of shares of the underlying stock at the “strike price” at any time prior to the expiration date. When the seller of the call option is the owner of the underlying shares then the option is deemed “covered” because the owner is able to deliver these shares without having to purchase them on the open market at as yet to be determined – often higher – future prices.

 

HOW TO PROFIT FROM COVERED CALLS

To secure the right to purchase shares in the future at a predetermined price, the seller is paid a “premium” to the seller of the call option. A “premium”is the fee paid in cash by the buyer on the date he purchases the option. The seller keeps this money regardless, whether the option is exercised or not.

 

WHEN TO SELL

Selling a covered call allows you to exchange some of your stock’s future upside for money in your pocket today.

To illustrate, you purchase your stock at $50 per share with the idea that it will go up to $60 within a one-year period. Plus, you’d consider selling at $55 in six months time, aware that you are sacrificing any further upside but satisfied with this profit for the short term. This is a situation where you might find it advantageous to sell a covered call on your stock position.

Upon examining the stock’s option chain, you locate a six month call option at $55 selling for $4 a share. This $55 call option could be sold against your shares, purchased at $50, which you hoped to be able to sell at $60 within 12 months. By doing this you would be obligating yourself to sell these shares within the designated six-month period if the stock reaches the $55 price. This would leave you with the $4 per share premium and the $55 per share from the sale, a total of $59 (a return of %18) for the six-month period.

Conversely, should the stock fall to $40, for example, you will have a $10 loss based on your original position. However, the $4 option premium from your sale of the call option, which you keep, offsets the total loss, making it only $6 per share instead of $10.

 

 

Scenario One

Shares go up to $60, and the option is exercised

January 1

You buy XYZ shares at $50 January1

You sell XYZ call option for $4 today
Option expires on June 30, exercisable at $55 June 30

Stock finishes at $60; option is exercised because it is above $55. You receive $55 for your shares. July 1

Total Profit: $5 (capital gain in the stock) + $4 (premium collected by you from sale of the option) = $9 per share, or 18%

 

Scenario Two

Shares drop to $40, and the option is not exercised

January 1

You buy XYZ shares at $50 January 1

You sell XYZ call option for $4 today
Option expires on June 30, exercisable at $55 June 30

Stock finishes at $40; the option is not exercised and expires, worthless, because the stock has finished below the strike price. ( Why would the option buyer still want to pay $55/share when he or she can purchase it in the market at the current price of $40?) July 1 Total Loss: -$10 + $4.00 = -$6.00, or -12%. You may sell your shares for $40 today, but you keep the $4 option premium.

ADVANTAGES OF A COVERED CALL

Selling a covered call option is a good way to offset downside risk or to increase upside return. However, it also means that you trade the cash you get from the option premium today for any upside profit beyond the $59 price per share, including the $4 premium. That is to say, if your stock finishes above $59, you end up worse than if you had merely held the stock for the six months, But if your stock ends the six month period at any point below $59, you end up ahead of where you would have been without selling the covered call.

RISKS OF A COVERED CALL

For as long as you maintain the short option position, you must hold onto the shares, or else you’ll be holding what is known as a “naked call”, which, theroetically, could have unlimited loss potential should the stock go up. Because of this, if you choose to sell your shares before the option expires, you will have to buy back the option position, costing you extra money plus some of your profit.

Want to Invest Smart? Keep it Simple

It doesn’t take an MBA to reach your financial goals. We show you how you can make money the easy way.
Who doesn’t want to be the next Warren Buffett? You could start by clearing  your schedule, buying some highlighters, burying your nose in annual reports and picking up the 800-page volume Security Analysis. Of course, that’s just for starters. Want to be simply a great investor? Then learn to invest simply.

The real secret to successful investing is that it is not actually all that complicated. Most of the jargon and hype doesn’t matter. You don’t really need to know what the difference is between a credit card and a credit-default swap, or between a convertible bond and a convertible sofa, in order to manage your own money. Common sense can take you further than an MBA.

Many investors sabotage their own results when they start trying to get fancy. “When investors start tinkering, they tend to second guess and buy things after they’ve gone up or sell things after they’ve  already gone down, which is a sloppy way to manage a portfolio,” says David Swensen, manager of Yale University’s $19.4 billion endowment and the author of Unconventional Success: A Fundamental Approach to Personal Investment.  Mutual fund investors, for example, have cost themselves an average of two percentage points per year over the last ten years by buying high and selling low, according to Morningstar fund tracker. Maybe we could mend our ways if we were able to see more clearly the evidence of how much our follies cost. But the more complex the investing , the more cluttered the accounts, and it becomes difficult to tell what your actual return is when your portfolio is something of a mess..

One of the few things that an investor can predict up front are costs. “There is only one thing that I am absolutely sure of about investing: The lower the fees that I pay to some purveyor of an investment service, the more there will be for me,” says Burton Malkiel, professor of economics at Princeton University, author of A Random Walk Down Wall Street.

Consider this, for example. Let’s suppose you’re preparing for your retirement by saving $10,000 a year for the next three decades. If we assume that your portfolio averages an annual return of 8% before fees, your retirement nest egg would be a bit more than $1 million – if your costs totaled only 1% a year. But if you had to pay 2% a year, you’d end up with $838,000. So you see, paying just one percentage point less per year translates into 21% more money at retirement time.

Breakout Stocks – Your Road to Riches?

Trading in stocks that initiate major  breakouts can be a path to massive profits. As soon as a stock trends to a new high, or takes out a former overhead resistance point, then it’s free to locate new buyers and momentum players that can, in time, push the stock up significantly in price.

A notable example of a successful breakout trade, recently, is BlackBerry maker Research In Motion (RIMM_), which I featured in Nov. 01′s “5 Stocks Under $10 Set to Trade Higher in November.” I wrote in that piece that RIMM was encountering some buying interest just above its 50-day moving average and it was beginning to trigger a breakout trade above some of its near-term overhead resistance levels at $8.08 to $8.49 per share with a decent upside volume flow. I said back then that if RIMM held that breakout, then the stock might ultimately hit $12 to $13 a share

 

And what happened? Plenty of shares of RIMM sold off a few days later from over $9 to $8.14 a share, but the stock never quite breached its 50-day moving average or its original breakout level of $8.08 a share. Shares of RIMM stayed in an uptrend and the stock continued to rocket towards a high of $12.30 a share. That’s showing a jaw-dropping gain of 55% in just the month of November for RIMM shares. Had you been focused on the breakout prices that I highlighted in that piece, then you would have been able to capitalize big off this move.

Candidates for breakout status are something that I tweet about on a nearly daily basis. I often tweet out high-probability setups, breakout plays and companies that are acting technically bullish. Those are some of the stocks that can go on to make strong moves to the upside. The great thing about breakout trading is that you can focus on price, volume and trend. You don’t have to pay attention to anything else. The charts will tell you all you need to know.

Trading breakouts is nothing new on Wall Street. This strategy was long ago mastered by legendary traders such as William O’Neal, Stan Weinstein and Nicolas Darvas. Those pros already understand that once a stock begins to break out above past resistance levels, and to hold above those breakout prices, then it’s no strecttch for it to trend significantly higher

Keeping that in mind, let’s take a look at five stocks that are beginning to set up to break out and trade at significantly higher levels

 

A name that is trending very close to a major breakout trade is Crocs (CROX_). The company is involved in the development, design, manufacturing, marketing and distribution of consumer products, mostly casual & athletic shoes & shoe charms, from specialized resins marketed as Croslite. The stock has been under control of the sellers for about the last six months, with shares down by 23%.

If you take a look at Crocs, you’ll notice that this stock dropped down in late October from around $16.60 to a low of $12.61 a share with very high downside volume. After that move, shares of CROX then went on to hit a low of $12 per share before bouncing back sharply to its current price of $13.80 a share. That recovery has now pushed CROX within range of initiating a major breakout trade to land back above its gap down day high at $14.04 a share.

Traders should now be looking for long-biased trades in CROX as it manages to break out above its gap down day high of $14.04 per share with high volume. Be on the lookout for a sustained move or close above $14.04 a share with a volume that lands near or above its three-month average volume of 276,850 shares. If this breakout triggers soon, then CROX can set up to re-fill some of that gap down zone that began at $16.60 a share.

Traders can expect to buy CROX off any weakness in anticipation of its breakout and may simply use a stop that sits just below some near-term support at $13 a share. One also might just buy CROX off strength as soon as it takes out $14.04 a share with volume and then place a stop that sits near $13.50 per share

Yet another stock that’s just beginning to flirt with a major breakout trade is Inteliquent (IQNT_), a company which provides full-scale network solutions, offering intelligent networking to resolve challenging interconnection and interoperability issues on a global level. This stock was destroyed by the sellers up until late in 2018, with shares off by disheartening 79%

If you examine the trading data for Inteliquent, you will see that this stock has been downtrending sharply for the last six months, with shares plummetting from $8.73 to its recent low of $2.10 a share. During this downtrend, shares of IQNT have consistently been making lower highs and lower lows, which would be considered bearish technical price action. Having said that, shares of IQNT are recently beginning to make a series of higher lows and higher highs, which is technical bullish price action. This stock is also beginning to rise off of previous oversold levels, since its current relative strength index (RSI) is reading at 26.50.

Wise market players would now look for long-biased trades in IQNT once it is able to break out above some near-term overhead resistance levels at $2.42 to $2.43 per share with high volume  Be ready for a sustained move or close above those points with volume that registers close to or above its three-month average action of 464,315 shares. If this breakout triggers soon, IQNT could then make a powerful bounce off oversold levels, with some possible upside targets being $3.50 to its 50-day at $4.41 a share.

One might look to buy IQNT off any weakness to be ready for that breakout and simply use a stop that sits close to some near-term support levels at $2.18 to $2.10 a share. One could also buy off strength once IQNT clears $2.42 to $2.43 a share with volume, and then use a stop close to $2.18 per share

Another name that’s beginning to move within range of triggering a big breakout trade is Aegerion Pharmaceuticals (AEGR_), which is aimed at the development and commercialization of therapeutics which treat lipid disorders. This stock was uptrending strongly through most of  2012, with shares up just over 40%.

If you look at the data for Aegerion Pharmaceuticals, you will quickly notice that this stock has been trending sideways for some time now, with shares moving between $18.33 on the low side and $23 a share on the high side. Shares of AEGR bounced higher in recent trading from $19.92 to just over $22 a share with acceptable volume. That spike has now pushed AEGR above someof its near-term overhead resistance at $21.66 a share, and it has moved it to within range of triggering a major breakout trade above $23 a share

Market players should now be looking for long-biased trades in AEGR as soon as it manages to break out above some near-term overhead resistance at $23 a share with high volume. Keep an eye out for a sustained move or close above $23 a share with volume that reaches near or above its three-month average action of 449,761 shares. If that breakout triggers any time soon, then AEGR will set up to re-test or possibly take out its all-time high of $25.92 a share

One last stock that is currently moving within range of triggering a near-term breakout trade is Zipcar (ZIP_), which operates a car sharing network. It is providing the freedom of ‘wheels when you want them’ to more than 560,000 Zipsters. This stock has been a regular target for the bears in 2018, with its shares down by 37%.

If you examine Zipcar’s data, you will notice that this stock has been strongly uptrending during recent months, with shares rocketing from a low of $5.90 to a most recent high of $8.64 a share. During that rise, shares of ZIP have mostly been making higher lows and higher highs, which would be bullish technical price action. That move has now landed ZIP within target range of triggering a near-term breakout trade.

Traders should now  know to look for long-biased trades in ZIP as soon as it is able to break out above some near-term overhead resistance levels at $8.64 to $8.69 per share with high volume. Look for it to make a sustained move or close above those level with a volume level that hits near or above its three-month average action of 350,502 shares. If this breakout triggers soon, then ZIP will set up to re-test or possibly take out its next major overhead resistance levels at $10.20 to $12 a share. And if that breakout hits, then ZIP should also move into a previous gap down zone from last August that started at around $10 a share.

Traders may look  to buy ZIP off any weakness during the period that it is trending within range of its 50-day moving average of $7.26 a share. One may also buy off strength from the time that ZIP takes out $8.64 to $8.69 a share and then simply use a stop close to $8 to $7.84 a share

Bear in mind that this stock has been heavily-shorted , since the current short interest as a percentage of the float for ZIP is 23.9%. The bears, also, have been upping their bets  from the most recent reporting period by 5.6%, which amounts to around 330,000 shares. If the breakout arrives soon, then ZIP could quickly see a monster short-squeeze as the bears rapidly move to cover some of their short positions.