Utilize Covered Calls To Lock In Profits

by: David Sims

Covered calls and other options trades could generate large profits for an investor. The mechanics of a covered call trade are simple to understand if you get down a few key concepts. The first and biggest key is that the covered call seller is giving up the right to unlimited profit. The second key concept is that the seller of a covered call is giving up short-term rights to stock appreciation in order to increase short-term profits. The investor is basically selling their rights to unlimited profits.

You may wonder why an investor would sell their right to profit from a stock, but consider the age old adage "buy low and sell high." Any investor in a stock should have, at the very minimum, a back-of-the-envelope calculation for their entry and exit prices for an equity. The lack of this analysis leads an investor to miss out on profit-taking when prices rise. Conversely, when prices drop, the lack of any fundamental analysis could lead to panic selling.

Thus, for investors holding stock in a company, a covered call gives them the opportunity to lock in a selling price when the stock's price rises dramatically. Investors in First Solar, Inc. (NASDAQ:FSLR), Netflix, Inc. (NASDAQ:NFLX), and Molycorp, Inc. (MCP) should consider an out-of-the-money covered call to produce higher portfolio income and profit from potential price improvement.

A November 2012 expiration covered call in First Solar could yield a potential profit of 13.8% over the next 53 days when holders of the stock sell the $21 call option. If the stock trades above $21, shares will automatically be sold at the expiration date. If shares trade below $21, the seller of the call gets to keep the $2.16 option premium. If shares fall to $18.45, the investor reaches a break-even point on the trade.

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Investors in Molycorp could profit from a similar covered call trade by selling the November 2012 $12 strike price call option for a premium of $0.87. If the share price rises above $12, the stock will automatically be sold for a profit of 17.4% over a period of 53 days. That's a potential annualized return of 118.30%. The break-even price on the trade is $10.22.

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Netflix investors may consider a covered call trade with a November 2012 expiration as well. By selling the $55 strike price call option against shares they hold, they will receive a premium of $4.85 for taking the position for 53 days. If shares are called, the profit will be 11.9%. If shares trade below $55, then the investor keeps portfolio income of about 9.5%. The break-even price on the trade is around $49.15.

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These hypothetical trades outlined above should be considered as part of a larger financial plan and due diligence surrounding the underlying stocks. Utilize covered calls to produce a disciplined strategy. Don't enter into any trade such as this without understanding the complexities of the transaction.

The calculations provided above are generated through an online calculator provided by the Options Industry Council.

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.