Profiting From Covered Calls In An Easy Money Environment

Includes: KBH, XHB
by: David Sims

With the Federal Reserve Bank's recent announcement of a third round of quantitative easing, dubbed QE3, you may be looking for ways to profit. Easy money should do something to help spur the recent housing resurgence. With mortgage interest rates remaining low for an extended period, housing investment should continue to grow.

A covered call transaction gives you the benefit of taking a long-term bullish position on a security, while placing a wager, that in the short term, asset prices will not surge beyond realistic expectations. By capping overall returns, you can actually boost your potential returns in the short-run, if the security doesn't move. With the Fed pledging to buy mortgage securities for an extended period, a reasonable investor would assume that housing has at least a few months to fully recover.

The SPDR S&P Homebuilders (NYSEARCA:XHB) index is a basket of stocks covering housing-related stocks. This includes everything from homebuilders to retailers that sell furnishings for homes. An investor selling calls against shares that they own would be creating a covered call trade. With this trade, they are giving up short-term appreciation in their stock for the limited income of the call option premium that they have sold.

The Options Industry Council has a convenient tool that helps calculate the rate of return on a covered call trade, including costs of the trade such as commissions. With this tool, we can see that selling the $26 strike price October 2012 call option against shares costing $25.87 would yield a return of 1.9%, if the price of the stock remains unchanged. This is an annualized return of 20.6%. If the price of the index rises above $26, the shares will be called and the total return capped at 2.4% (26.21% annualized). The break-even point will be reached on the trade if the index drops to $25.39.

XHB Covered Call
(Click to enlarge)

If you want to increase risk, you could look into trading covered calls on individual stocks, such as KB Home (NYSE:KBH). With shares trading at $13.65, you could look at selling the October 2012 $14 strike price call for $0.69. With reasonable commissions, you could potentially reward yourself by receiving option premium income yielding about 3.7% over about 33 days, if the stock doesn't appreciate above the strike price. If the stock trades above $14, you sell your shares and receive a total return of about 6.4% over this period, which is an annualized return of 69.63%. Your break-even price becomes $13.16 after selling these calls.

(Click to enlarge)

When trading covered calls, be reminded that your downside protection is limited to the amount of the option premium you have sold. Also, be aware that your upside is also limited to the profit received from selling at the strike price plus the option premium.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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