Covered Calls: Cash In Before Fiscal Cliff Part 2
Last week investors sent stocks soaring higher once it became clear a deal would be made to avoid the fiscal cliff.
The S&P 500’s 4.5% surge was one the indexes best weeks in years. It also pushed the large cap index to its highest close since 2007.
But we’re already beginning to wonder how long the bullish momentum will last.
And for good reason…
As I’m sure you know, the deal to avoid the fiscal cliff wasn’t the grand bargain between Democrats and Republicans many had hoped for. It simply extended the Bush tax cuts for the majority of Americans and put off the automatic spending cuts for two months.
The decision to punt the spending cuts down the road two months creates another cliff and sets the stage for another political showdown. And this time the deadline coincides with another Washington favorite… the debt ceiling.
The last time politicians voted to increase the debt ceiling in order to avoid defaulting on the country’s debts they waited until the last minute. It prompted ratings agency Standard & Poor’s to downgrade the credit rating of the US.
The bottom line is politics will once again create uncertainty. That’s never good for stocks because investors hate uncertainty. And it will certainly make it difficult for the bullish momentum to carry over going forward.
In other words, there’s clearly bullish momentum in stocks but until fiscal cliff part 2 is dealt with, it will likely prevent them from soaring much higher.
With that in mind, it looks like a good opportunity to use a buy-write strategy.
Buying a stock and immediately selling a call against it does two things. It gives you the ability to make more money on a smaller move in the stock price. And it gives you a bit of a cushion in case the stock moves against you.
Take homebuilder D.R. Horton (DHI) for instance…
DHI is trading for $20.78 today. You can buy 100 shares of the stock for $2,087. And you can sell the February 2013 $22 call option for $0.47. So you’ll collect $47 or 2.2% of the stock price in option premium. The $22 strike is $1.22 or 5.8% above the current price.
If DHI is trading for $22 or more when the option expires on February 15th, the 100 shares of stock will be called away or sold for $22 apiece. The trader will record a gain of $122 on sale of the stock. Plus, you get to keep the $47 in option premium.
Your total profits on the trade are $169 or 8.1%. In order for you to get the same 8.1% return by simply owning the stock, DHI would need to reach $22.47.
However, if DHI is below $22 when the options expire in January, the option will expire worthless. You get to keep the $47 in option premium and you’ll still own 100 shares of DHI.
What’s more, the option premium you collected gives you a 47 cent per share cushion if the stock moves against you. If DHI falls to $20.31, you’re still breaking even.
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. It also gives you a bit of protection from the stock moving lower. It could be just the thing you need to generate outsized profits until fiscal cliff part 2 is resolved.
Good Investing,
Corey Williams
Category: Options Trading
