Over the last couple of months, traders have been hard-pressed to find smooth-trending stock charts. As Thursday�s session has shown again, there has been a lot of choppiness in the market, which has created volatile price swings.
A covered call strategy � buying the stock (or already owning it) and selling a call option against it — is generally used to generate additional income for a stock position. Huge price swings down are generally not ideal, because of the long stock position. Substantial losses can incur in which the short call�s premium will not cover.
When searching for covered call candidates, an ideal stock chart would be trending just slightly upward or staying relatively neutral. A covered call can profit even if the stock trades sideways, because if the short call expires worthless, the premium is yours to keep, which helps offsets the cost of the stock.
MasterCard (NYSE:MA) looks like a nice candidate — although an expensive one. The company has solid fundamentals, posting three straight quarters of accelerating sales. The stock has had some sizeable price swings, but it has always managed to trend higher.
MA recently hit an all-time high of just over $360. That looks like a nice target and the strike to sell. Its previous resistance was at $340, which will hopefully become new support for the stock even though it has fallen below that mark so far in Thursday�s broad selloff. This trade gives the stock some upside potential to go higher and the break-even point on the trade will be well below support.
The Trade: Buy 100 shares of MA at $341 and sell October 360 call at $7.50
Cost of the stock: 100 x $341 = $34,100 debit
Premium received: 100 x $7.50 = $750 credit
Maximum profit: $2,650 — that�s $1,900 ($360 � $341 x 100) from the stock and $750 from the premium received if MA finishes at or above $360 at October expiration.
Break-even: If MA finishes at $333.50 ($341.00 � $7.50) at October expiration.
Maximum loss: $33,350 if MA goes to $0 at expiration.
The goal with a covered call is for the stock to rise up to the sold call�s strike price — $360, in this case. The stock moves up the maximum amount without being called away and the sold call expires worthless.
If the stock moves past $360 and looks like it�s not going to slow down, then the call that was previously sold (October 360) can be bought back and a higher strike can be sold against the position to avoid assignment. This will allow the stock to remain in the portfolio and also give the position a chance to increase its return.
The whole position can always be closed out and profits can be taken early before expiration. The company is scheduled to announce earnings on Oct. 31.
Every trade should have defined risk and loss parameters in place even if the trader or investor is just �paper trading.�
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