Options Mailbag: How to Trade 'Em, How to Win
02/08/08 - 03:23 PM EST
Steven Smith
This strategy is often employed as a means of generating income or setting a price target at which one would be willing to sell the stock. In the example above, with Apple trading around $125, one can sell the March $130 call for around $6 a contract. Profits are capped at $11, or 8.8%, if AAPL is above $130 on the March expiration. As an means of generating passive income, one can earn $6, or about 4.8%, if shares of Apple just stay at $125 for the next five weeks. Not bad.
But don't think this is the conservative strategy it is often proclaimed to be. Its risk/reward profile is nearly the same as selling short the March $120 put for a $6 a contract; that represents your maximum profit if shares of Apple are above $120 on the March expiration. This may surprise some people who have taught that naked short-selling is the most risky option strategy and should never be used. In this case, the tradeoff is that a covered call offers a larger profit potential but actually has a higher risk. It has a downside breakeven of $119 -- as the stock declines, the losses mount. Selling the $120 put naked gives you a break-even of $114 a share; as the stock declines below that point your losses mount. In general, when screening for covered-call candidates, I look for stocks that have been beaten down but are approaching a support level on the chart and have relatively high implied volatility. Here are a few names that currently look attractive -- I don't think they will hit their downside break-even point. I hate to endorse a market that could be a bursting bubble, but the iShares FSTE/Xinhua(FXI Quote - Cramer on FXI - Stock Picks), a Chinese exchange ETF, is currently trading around $141.50 and has support at the $137 level. One can sell the March $150 call for about $8 a contract. NYSE Euronext(NYX Quote - Cramer on NYX - Stock Picks) has sold off sharply, and shares now sit at $69, which offers moderate support. One can sell the March $72 call for around $2.50 a contract. That gives you a maximum profit or an effective sale price of $74.50, a return of $5, or 7.5%, over the next five weeks. It is also exposed to almost unlimited losses -- the stock can't go below zero should the shares decline below the $66.50 downside break-even point. Still, that's a reasonable 3.5% cushion for a stock that looks to be oversold.
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