Covered Calls: Catch More Upside With A Buy-Write Strategy
The S&P 500 has gone up six weeks in a row and it’s trading near multi-year highs. But you wouldn’t know how well the market has performed lately by simply looking at investor sentiment.
According to the weekly sentiment survey from the American Association of Individual Investors, bullish sentiment has fallen nearly 10% over the last two weeks. It’s the largest decline of investor sentiment since last summer and it’s a clear indication retail investors are losing faith in the rally.
Why are investors losing faith in the rally?
As I’m sure you’ve noticed, the pace of the rally has been steadily slowing from one week to the next. Last week the S&P needed a strong Friday rally to push the index into the green for the week.
Needless to say, last week’s market action wasn’t exactly the same bullish flurry as we had seen in the weeks prior. What’s more, the S&P is within 60 points of reaching the all-time highs it set back in 2007.
In my opinion, the slowing pace of the rally, combined with the technical and psychological hurdle of the all-time highs, has taken the wind out of the sails of some investors.
But keep in mind, the S&P is still 4% below the all-time highs it hit back in 2007. And there’s really no technical resistance between the S&P’s current levels and the all-time highs.
In fact, I’d be shocked to see the S&P correct before it makes a run at 1,576. That upside creates 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 tech company NetApp (NTAP) for instance…
NTAP reports quarterly earnings this week. The stock is trading for $35.35 today. You can buy 100 shares of the stock for $3,535. And you can sell the March 2013 $37 call option for $1.23. So you’ll collect $123 or 3.5% of the stock price in option premium. The $37 strike is $1.65 or 4.6% above the current price.
Let’s see how this trade can work out…
If NTAP is trading for $37 or more when the option expires in March, the 100 shares of stock will be called away or sold for $37 apiece. You’ll collect a gain of $165 on the sale of the stock. Plus, you get to keep the $123 in option premium.
Your total profits on the trade are $288 or 8.1%. In order for you to get the same 8.1% return by simply owning the stock, NTAP would need to reach $38.21.
However, if NTAP is below $37 when the option expires in March, the option will expire worthless. You get to keep the $123 in option premium and you’ll still own 100 shares of NTAP.
What’s more, the option premium you collected gives you a $1.23 per share cushion if the stock moves against you. If NTAP falls to $34.12, 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.
This strategy could be just thing you need to generate outsized profits as investor confidence fades as stocks approach all time highs.
Good Investing,
Corey Williams
Category: Options Trading
