Covered Calls: Shopping For Big Returns On Small Price Gains

| November 26, 2012 | 0 Comments

Holiday shopping is in full swing…

Retailers are hoping the introduction of more branded shopping days will entice consumers to spend more money than ever.

It began with Black Friday, the day after Thanksgiving.  Then Super Saturday, the Saturday before Christmas popped up.  And then the internet gave rise to Cyber Monday, the Monday after Thanksgiving.

Just a few years ago, American Express (AXP) coined Small Business Saturday to encourage consumers to shop at local businesses.  And this year, retailers invented Gray Thursday to entice shoppers into stores on Thanksgiving.

And it looks like their plan is working…

So far, retailers are reporting a strong start to the holiday shopping season.  It’s estimated that consumers spent $59 billion over the first three days… an increase of 12.5% over the $52.4 billion consumers spent last year.

What’s more, Cyber Monday is expected to be huge this year.  Online shopping on Black Friday surged more than 20%.  And more than half of all consumers are planning to take advantage of Cyber Monday deals online this year.

Will the shopping surge last?  And more importantly, will it be enough to fuel more upside in retail stocks?

At this point, I believe retail stocks have limited upside.  And it creates an opportunity for option traders to use a buy-write strategy to capture solid profits in the weeks ahead.

A buy-write is simply a covered call strategy.  A trader buys a stock and then sells a call option against the long stock position to collect the option premium.  This strategy gives traders the ability to generate bigger profits on a small move to the upside than if they just bought the stock outright.

When executing a buy-write, I look for situations where you can collect at least 3% premium and have 3% upside in the stock.

In essence, this allows you to collect 3% of the purchase price of the stock in option premium when you sell the call option.  And the strike price of the option is 3% above the current price.

Take jewelry retailer Tiffany (TIF) for instance… 

TIF is trading for $62.07 today.  You can buy 100 shares of the stock for $6,207.  And you can sell the January 2013 $65 call option for $2.00.  So you’ll collect $200 or 3.2% of the stock price in option premium.  And the $65 strike is $2.93 or 4.7% above the current price.

If TIF is trading for $65 or more when the options expire on January 18th, the 100 shares of stock will be called away or sold for $65 apiece.  The trader will record a gain of $293 on sale of the stock.  Plus, you get to keep the $200 in option premium. 

Your total profits on the trade are $493 or 7.9%.  In order for you to get the same 7.9% return by simply owning the stock, TIF would need to reach $67.00. 

However, if TIF is below $65 when the options expire in January, the options will expire worthless.  You get to keep the $200 in option premium and you’ll still own 100 shares of TIF.

As you can see, a buy-write strategy is a good way to generate bigger gains on a smaller move in the stock price than simply buying the stock.

Good Investing,

Corey Williams

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Category: Covered Call Writing

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.