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A covered call investor's favorite time to be sitting in cash is when the market outlook is at its worst. This leads to investors paying much higher for protection, and thus increasing call and put premiums. After a stock has been beaten down, long-term covered calls can be written at the money for a very hefty premium. One company where this is currently the case is Genworth Financial (NYSE:GNW). A good place to look at the outlook of the company is Here; this article is simply about how to profit from a potential rebound using either a simple more risk averse covered call play, or combining a covered call with selling in the money put spreads.

Covered Call Play

Genworth's 52-week range is 4.80 - 10.71, and it closed today very close to the bottom at 4.94. For someone that isn't too sure if the turnaround could happen today, in 6 months, or 2 years but doesn't want to time it selling longer term calls can be an effective strategy. This doesn't require constant monitoring, it gives greater downside protection, and can also limit trading mistakes from constantly trying to time the market. For example, a January 2013 $5 covered call (excluding commissions) is currently going for around $4.04. Below is the risk profile of each of the calls for the next 7 months through expiration.

 

 

   Return @
StrikeBEDownside Protection$4$5$6$7
54.0422.28%-0.99%23.76%48.51%73.27%
64.4112.02%-9.30%13.38%36.05%58.73%
7.54.675.78%-14.35%7.07%28.48%49.89%

One note is to not be afraid to leave a little on the table close to expiration if it is clear the risks have tilted to the downside. While above was the current risk profile, it will look vastly different near expiration. If you have done the $6 covered call option, and the stock is at $6.75 with a month remaining, you can likely exit the position for around $5.85 to $5.90. Your only remaining upside here is to $6 so it may be prudent to give up the .10 instead of keeping an unlimited risk to the downside.

Covered Call and Sold Put Spreads

The next idea is for the more advanced option trader that is willing to lock up a large amount of buying power in this trade. This requires the conviction that there is a pretty firm floor below the stock in the $4 area because it carries much more downside.

This trade is made up of the following:

January 2014 $5 covered calls for $3.30.

Sell January 2014 $10 puts, buy January $7 puts for a net price between $2.35-$2.50.

In selling put spreads, this will eat up margin equity in the amount of the maximum cost to close the trade. In this example it is $3 to close out the $10/$7 spread, but the premium of $2.35 - $2.50 (based on liquidity in the bid/ask spread) limits the max loss to $.50-.65 on this part of the transaction. With the 19 months until expiration this is a cheap way to play a large rally in the housing market, along with a calculated risk.

By selling the at the money calls on top of the stock, the break-even on the stock is an extremely cheap $3.30. Below is the risk profile of this trade done with a mock 25 contracts, and 2,500 shares. Including commissions (using OptionsHouse pricing structure) the cost is $2,132, and the break-even is right around $3.85. This gives downside protection of 28.3%. The maximum cost to buy back the puts is $7,500 and theoretically the stock could go to $0, so the maximum loss is $9,632. Between $5 to $7 this would cash out for $5,000 for a gain of $2,868, and the maximum possible value of the transaction is $12,500 (2,500 shares sold for $5, and $0 to buy back the puts above $10).

(click to enlarge)

Things to keep in mind if entering this transaction:

Make sure to calculate how this will affect your buying power (may differ depending on the broker). When a stock drops below $4 the margin equity may only count as the price of the stock - $2, vs 70% of the value. If entering this transaction lowers the portfolio buying power close to 0 it can result in a margin call if the stock drops below $4.

Continue to monitor and update the risk profile of the transaction over time. If the stock rallies to $6.50 early next year and IV has dropped, it may be a good time to close out all legs and put the cash tied up in the puts to work elsewhere.

The larger the desired position, the more expensive it may be to enter and exit this position. While the bid/ask may be liquid around 20-30 contracts there are no guarantees that 2014 options will be heavily traded above that size. It may seem like a good time to exit the position, but there could be a .40 bid/ask spread on the puts.

Don't be afraid to separate the legs of the trade down the line. It could make sense to sell the covered calls if the stock is $7.50 next summer if you can get close to the $5 maximum, while leaving the puts open for a potential farther rally. Also if the stock has gone down to $4 in 2013 and it looks impossible to see $7 by expiration, closing the puts for even $2.80 or $2.90 while holding the stock can make sense. As always stay on top of the trades, and do not treat them as a buy and hold strategy.

Disclosure: I am long GNW.

Source: A Leveraged Genworth Option Recovery Play