3 Covered Calls To Hedge Risky Stocks

covered callsYou can earn very big money with these covered calls, but beware, because these stocks are ripe for a fall

When it comes to growth or momentum stocks, there are some investors who don’t care about risk. They just buy up the big names and let it ride. Certainly there is some merit to this approach if one’s risk tolerance is high enough.

I’m sure many readers own these stocks. But I think they are overvalued and we are headed for a correction, so now is the time to at least hedge your downside with covered calls.

Covered calls give you the opportunity to sell the right for another investor to buy your stock at a given price on or before a given date. You earn a premium for selling this right. If you use a high-priced growth or momentum stock with covered calls, and you sell that right several months out, you can make a sizable premium.

That premium can serve as a downside hedge and as immediate income. My stock advisory newsletter, The Liberty Portfolio, uses covered calls but avoids these momentum plays because they carry too much risk. The Liberty Portfolio concentrates on lower-risk stocks that offer opportunities for additional monthly income.

Covered Calls: Chipotle Mexican Grill (CMG)

Chipotle Mexican Grill, Inc. (NYSE:CMG) is still struggling. Once the food-borne illness issue broke, CMG stock never was able to recover. Even though the issue itself was resolved, faith in the company was undermined. In the fast-casual restaurant business, it is too easy to lose business to another chain.

Still, some investors hold the stock and some see it a value play. To me, if you insist on holding it, then sell covered calls.

CMG stock closed Wednesday at $397, which is 20% off its 52-week high and almost 50% off its all-time high. The 15 Dec $400 covered calls are selling for $29. That means you would collect $2,900 right now, and give you a 7% downside hedge. That translates to a 7% return for a five-month holding period.

CMG’s 52-week low is $353, so you’d be hedging yourself almost all the way to that point.

Covered Calls: Alphabet (GOOGL)

Truthfully, I see Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL) as a growth stock but not necessarily as a momentum stock. I think of those as rising in a totally irrational manner with no real fundamentals behind it. GOOGL stock has excellent fundamentals, and on a net-cash basis, is trading at a fairly reasonable multiple.

Still, it is getting pricey in a pricey market. GOOGL stock trades at 29x net income, if you back out the net cash position. On a 19% annualized growth rate estimate, that’s not at all unreasonable.

GOOGL stock presently trades at $967 and has $150 per share in cash, meaning its net-cash price is $817. I’d love to find a very high priced set of covered calls for GOOGL stock.

If you sold the 15 Dec $960 covered calls, you would get a whopping $61 per contract, or $6,100 in cash. That’s 6.3% for a five month holding period and a nice downside hedge.

Covered Calls: Netflix (NFLX)

The granddaddy of momentum stocks without supporting fundamentals is probably Netflix, Inc. (NASDAQ:NFLX). I see no justification for NFLX to have a $68 billion market capitalization.

It is burning cash at a rate of $1 billion a year or more. It barely has a profit. It keeps having to issue debt to fund its programming. I love Netflix as a product, but as a stock, it’s just nuts to own it. You have to be careful with NFLX stock. The market is over the moon about it these days, but that love affair could end in a heartbeat.

Still, investors have bid it up to $159 per share as of Wednesday’s close. The 15 Dec $160 covered calls have a very generous premium of $14.50 per contract. You pick up $1,450 per contract, which is a 9% return, better than the other previous ideas.

Frankly, you’ll need all the downside protection you can get if you insist on holding NFLX stock.

Note: Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing.

 

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