Covered calls are one of my preferred option strategies because they generate positive returns, produce immediate cash, and allow you to reduce your cost basis in stocks that you want to purchase. A covered call involves going long a stock and short calls against the underlying position. The stock ownership still exposes you to the risk of loss but the option premium received is yours to keep regardless of what happens to the underlying stock. I write calls against my core investments on a weekly or monthly basis to effectively create synthetic dividends to enhance my returns. When looking for attractive covered call opportunities, I consider the following among other factors:
- Underlying financial position, performance, and valuation
- Stock volatility as elevated volatility results in higher premiums
- Key dates (dividends, earnings announcements, product announcements, etc.)
To capitalize on three attractively priced stocks, I have highlight three covered call opportunities: Western Digital (WDC), General Motors (GM), Smith & Wesson Holding Corporation (SWHC). The beauty of this strategy is that it drives the already low forward price/earnings ratios lower by reducing your effective net price paid for the position. Although I envision these as short-term trading ideas, you still need to exercise caution. The information presented below should simply be a starting point for further research in consultation with your professional financial advisor before you make any investment decisions. My goal is to present new companies to you and provide a brief overview of their recent developments and this should not be considered a substitute for your own due diligence.
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Western Digital: Buy at $45.48; Sell Sept. $46 Call at $1.70 - Net $43.78
Western Digital recently set a new 52-week high after reporting great earnings and is up 47% year-to-date. I continue to recommend WDC because it is affordably priced and produces hard disk drives that are in constant demand for cloud storage. Despite being bullish on WDC, I am fond of the slightly out-of-the-money calls because they can generate in excess of 40 percent annualized return even if the stock remains unchanged. The stock can certainly rise further but I am willing to sacrifice upside for the safety of the $1.70 option premium.
General Motors: Buy at $22.01; Sell Dec. $22 Call at $1.64 - Net $20.37
General Motors has traded in a tight range between $19 and $20 for the past month and only recently broke out to $22. The stock has faced pressure earlier this year due to concerns about the company's European operations. Barclays analyst Brian Johnson recently called a bottom for U.S. automakers and I agree with his investment hypothesis which relates to new truck platforms and potential European restructuring. I am not overly bullish on GM but at this price, I believe the downside is limited. For this covered call, I utilize an at-the-money option with a longer duration as I anticipate GM falling back into its pattern of trading in a range. For further details on GM, please refer to my article on the stock.
Smith and Wesson Holding Corp.: Buy at $8.23; Sell Sept. $8 Call at $0.85 - Net $7.38
Smith and Wesson has had a great 2012 as its stock has nearly doubled year-to-date. The stock hit $10 before declining back into the low $8 territory following analyst downgrades. Both analysts make the argument that the stocks are due for a decline as their valuation overheats. As you can see from the table above, the forward P/E for SWHC is still a very favorable 11.1. It is unrealistic to expect such gains to continue far into the future but I still believe that SWHC can continue to outperform the S&P 500. The call I have selected is already in-the-money by nearly 3 percent and can generate 10 percent returns in less than a month by simply staying above $8. When a stock has appreciated this month, it is wise to build in a downside cushion to mitigate potential losses.
Additional disclosure: Author is long GM and WDC; short GM September $21 Calls.