Last week I showed you why I like covered calls so much.
I know many of you like them too, because the feedback I received for the covered call article was overwhelmingly positive. And that makes perfect sense.
Covered calls are among the simplest options strategies. They’re easy to understand and easy to execute. Best of all, they give you a safe way to immediately juice your return on investment (or ROI) on stocks you already own (although there’s one instance where you do NOT want to use them – keep reading for that).
So today I’m going to follow up on my promise to give you a specific example of a covered call opportunity to act on.
I think you’re going to like this trade.
Here’s the perfect stock to sell covered calls on this week.
A Quick Recap… and When NOT to Use Covered Calls!
I am first going to retouch on some of the key things about the covered call that must be taken into account before you venture off into the use of this strategy. I will then come through on the covered call idea.
A primary observation is there are other, less cash-intensive – and thereby less risky – ways to go about cash flowing the market.
That being said, the safety in the covered call is the fact you are just that: “covered.” You own the stock, and stocks do not expire like options do.
So long as you believe in the company and its long-term prospects for higher price appreciation, by all means, hold the stock and continue to write covered calls on it as long as you can.
The other side of that is, you may get “called out” of your stock or have the stock bought from you. If you don’t mind having the stock “called away” or bought from you, by all means consider this strategy.
But if you do not want to have this stock purchased or called away from you then don’t even risk that happening by putting it up for sale. Do NOT write covered calls on stocks you want to keep!
For those of you that like the idea of owning stock, maybe collecting the dividends along the way, and getting paid maybe on a monthly basis just for putting the stock up for sale, aka writing a covered call, here is the trade idea.
GMCR’s “Rounded Bottom” Pattern
Take a look at the chart on Keurig Green Mountain Inc. (NASDAQ:GMCR).
I pointed out on the chart it shows a rounding basing pattern. This is also known as a saucer bottom and others will call it a cup and handle without the handle. I would like to see GMCR inch its way up to $80 to complete the rounded bottom or saucer pattern for me, but here is why I point this technical pattern out.
Rounded bottoms usually happen after periods of significant decline. The decline for GMCR happened off its earnings miss back in the first week of May. The true completion of the rounding pattern would be all the way back up to $110.
I am looking at this smaller rounded base from a breakdown of consolidation at $80.
This is a reversal pattern that is usually more difficult to find, due to how long term in nature it is. It typically lasts a few months to years for it to work itself out to the upside.
For a covered call writer, this should be music to your ears.
If this takes months to years to work out, that could give us longer time to continually work this strategy with this stock – and take more and more low-risk profits.
There are two ways this could go:
- If you write the calls and it does not get called out, what happens? You keep the stock AND the premium on the call option you sold.
- If you write the calls and you get called out or sell the stock, you keep the premium and make the gain on the sale of the stock.
The longer-term nature of this stock’s movement to get back up to previous higher levels may give you the chance to buy back into the stock and work the strategy again. I will show you the numbers at the time of this writing (Monday afternoon) to show you what the covered call looks like to set it up, the ROI for doing so, and the potential ROI if called out.
Here’s How the ROI Can Shake Out
First, here is the trade:
I am going to discuss the trade over 100 shares. You can buy as much as your money management rule will allow for your account, just remember in order to write or sell one call option contract you need 100 shares.
The ROI initially on this trade is the premium you took in for the sale of the call option divided by your stock purchase price. It cost $76 to buy the stock and you sell the GMCR Aug15 80C for $2.67, making the initial ROI 3.5%.
That will be the situation if the stock DOES NOT get called away.
Should the stock get called away, which again, you do not mind – otherwise you would not use this strategy – you will keep the call premium you sold to begin with and make a capital gain on the sale of the stock.
Since you bought the stock for $76 and you get called out or sell it at $80, you take into the account another $4.00 per share. Again, one contract is the right to 100 shares. So you take in an extra $400 ($4.00 x 100 shares) less fees and commission when that happens; most likely at expiration.
So let’s look at the ROI for that situation.
You make $2.67 for selling the call and another $4.00 when called out, equaling a total of $6.67 per share, or $667. So $6.67 divided by the stock price of $76 makes your ROI when that happens 8.7%.
See below (all done on a one-contract basis):
COVERED CALL ONLY: IF CALLED OUT:
Stock purchase: $76 Stock Purchase: $76
Sold Call Option: $2.67 Sold Call Option: $2.67
Not Called Out Gain: 0 Called Out Gain: $4.00
ROI Not Called Out: 3.5% ROI Once Called Out: 8.7%
If you are not called out, you keep the $2.67 and can price out the options for next month and try it again. If called out you can decide to either move on to another stock or wait for a price you like on GMCR, buy back in again, and start the process all over again.
If you are called out you get the extra capital gain, in this case.
One Last Thing on GMCR…
One last thing on GMCR. They are due to report earnings on August 5. Either of the two above scenarios could play out even more so, because of this. GMCR’s price action could go down based off the report and forward-looking guidance, or it could go much higher.
You know your ROI ahead of time for either scenario.
The thing to ask yourself is are you going to be ok with owning GMCR if it goes much lower than it currently is before the report. If so, stay with the strategy and know that you can keep utilizing the covered call strategy at lower stock prices to try and recoup any losses in stock price.
Despite the cost, the covered call strategy is one that provides the chance to generate monthly cash flow utilizing a stock vs. just time-sensitive options.
Americas #1 Trader