Rackspace: Highest Returning Protected Covered Call

Jun.10.12 | About: Rackspace Hosting, (RAX)

Rackspace (NYSE:RAX) offers cloud, managed and custom hybrid hosting. Rackspace integrates the industry's best technologies and tailors it for each customer's specific need.

In Rackspace's Q1 2012 earnings call held on May 7, 2012, the company indicated they are making investments in order to strengthen their market position. The company's development plans for this year revolve around the open-source platform OpenStack. The company announced the release of seven next-generation public cloud products: 1) Cloud Servers powered by OpenStack, 2) Cloud Databases power by OpenStack, 3) new control panel with a graphical user interface, 4) Cloud Networks, 5) Cloud Block Storage, 6) Cloud Monitoring and 7) Cloud Backup. The number of companies involved in the OpenStack Foundation has increased from to 168 from the previous year's 60.

Rackspace's stock price has taken a hit recently as shown below:

The stock's price is near the 200 day moving average, but is off of the previous support level in the $40 price range, has a very high Price-to-Earnings (P/E) ratio of 72 and the stock does not appear to be forming a base, as of yet.

Rackspace's competitors include Amazon (NASDAQ:AMZN), AT&T (NYSE:T), SAVVIS (private) and Verio (private).

A current investor in Rackspace's stock might consider a protected covered call, as it positions an investment in Rackspace for a potential return, yet protects against a large drop in price. A protected covered call may be entered by selling a call option against a purchased or existing stock and using some of the proceeds from selling the call option to purchase a protective put option.

A protected covered call or collar search performed using PowerOptions tools, seeking to find the highest returning position for companies with a maximum potential loss of 8% and a stock price in an uptrend, produced Rackspace Hosting as shown below:

Click to enlarge

Other stocks with potential returns worthy of mentioning include pharmaceutical company Vertex Pharmaceuticals (NASDAQ:VRTX), entertainment technology company IMAX (NYSE:IMAX), life sciences company Illumina (NASDAQ:ILMN) and natural gas company Cheniere Energy Partners (NYSEMKT:CQP).

The Rackspace protected covered call has a potential return of 3.7% (30% annualized) with a maximum potential loss of 7.6%, so even if the price of the stock drops to zero, the maximum loss experienced is 7.6% (at expiration).

The highest returning positions as shown above were found by selecting to search and sort by the highest returning positions. Stock prices for companies in an uptrend were found by selecting to include companies with a 100-day moving average greater than the 200-day moving average. The 8% maximum loss parameter was selected, as a loss of 8% or less can typically be recovered fairly quickly using income generating investment methods. The search was performed for stocks with a price near the lower Bollinger band, as stocks with prices near the lower Bollinger band may be basing for the next leg up in price.

A current investor in Rackspace might consider entering the highest returning protected covered call listed in the table above, as it positions the investment for a potential return, yet protects against further large drops in the price of the stock. The specific call option to sell is the 2012 Jul 45 at $2.85 and the put option to purchase is the 2012 Jul 40 at $1.25. A profit/loss graph for one contract of the position is shown below:

For a stock price below the $40 strike price of the put option, the value of the protected covered call remains unchanged (at expiration). If the price of the stock increases to around $45, the position can most likely be rolled in order to realize additional potential return.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.