Taking Advantage of WMT Using the Covered Call

A call option is the right to buy a stock for a set price, for a set period of time. For example, the Wal-Mart (WMT - commentary - Cramer's Take) June $52.50 call option is the right to buy WMT from now until the third Friday of June at $52.50 per share. The buyer of the call is usually a speculator hoping it will go higher than that.

The conservative approach to options would be to be the seller of the call. In other words, you give someone the right to buy your WMT stock at $52.50 until June, and the buyer pays you the market-determined price for that option. Right now, the WMT June $52.50 call option is trading at $1.75. So let's put on a trade.

We buy WMT at today's price of $49.66 and sell in the options market the right to take our stock from us at $52.50 from now till the third Friday of June. (I think it's actually the Friday preceding the third Saturday, but I'm getting confused.) The buyer pays us $1.75 for that right. So right away, we are protected for $1.75 in downside. If we wanted to buy WMT anyway, this is a good thing.

Now on the upside, we have to be prepared to part with our stock at $52.50 if it should get there or go higher. The buyer can "call" our stock from us. If that happens, we, in effect, sell our stock at $52.50, plus $1.75 (which is the premium we received for the call option), for a total of $54.25.

We bought the stock for $49.66, and we sell it for $54.25 for a gain of $4.59, or 9.24% (excluding transaction costs.) Since this would be completed by June, or roughly four months from now, our annualized gain would be 28.9% (again, excluding transaction costs.)

We could always "buy in" the call option at any time at the then prevailing price. Suppose WMT was at $53.50 the third week of June. The option to buy the stock at $52.50 would be trading close to "intrinsic" value of $1 and no more, since there would be no "time premium." Intrinsic value would be the $1, since the right to buy at $52.50 if you could turn around and sell at $53.50 would be worth the $1 difference and no more, if there was no more time to hope for a rise in the stock.

What we would do is buy the option back and make $1.75 minus $1, or $0.75. And we would still own WMT and have had some downside protection.

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At the time of publication, Farrell and or Scotsman Capital Management were long Wal-Mart.

Vincent Farrell Jr. is a principal of Scotsman Capital Management. Prior to joining Scotsman in April 2005, Farrell was chairman of Victory Capital Management of Cleveland and chairman of Victory SBSF Capital Management in New York. He was a founding partner of Spears Benzak Salomon & Farrell, which was acquired by KeyCorp in 1995. Vince held a variety of positions in his 23 years at SBSF, including chief investment officer, and he served as the portfolio manager on a number of the firm's largest client relationships. He is a regular guest on CNBC as well as other national print and broadcast media.

Prior to joining SBSF, Vince spent nine years at Smith Barney as a vice president, sales.

Vince graduated from Princeton University in 1969 and received his MBA from the Iona College Graduate School of Business in 1972.