There may be some pausing on the charts. The S&P 500, NASDAQ and Russell 2000 all breached their respective 50-day moving averages (MAs) this week but rebounded. There is some hesitancy. First-quarter-earnings season is drawing to an end with some decent results. With 464 S&P 500 companies having reported as of May 17, 69% have exceeded expectations, while 20% of the companies were short. The blended growth rate for the first quarter has been impressive at 18.6%—up from 12.2% on January 3, 2010. Again, these are decent results, but keep in mind that 31% of the companies did fail.
Moreover, the other critical element, the economy, is showing some softness in manufacturing and continued weakness in housing.
Following a strong April, stocks started on a down note in May, with eight down days out of 13. Based on historical trends, this is not a surprise. The best part of the year for making money is the period from November to April, which historically is the best six months of the year for stocks, according to the Stock Trader’s Almanac.
This means that stocks may waver as we head into the traditionally slower summer trading months. Markets have been showing some neutral bias after failing to break higher, and without leadership, markets may stall. Should this happen, my investment advice would be to write some covered-call options to generate some premium income and reduce the average cost base of your positions. Be careful, though, as a market surge could take out your position at the call strike price. Make sure that you are comfortable with the strike price of your covered call.
I have long favored the use of writing some covered call options on long positions should the market trade flat. This may be the case now.
Why let your positions sit idle? Write some covered calls to generate some premium income, and help reduce your average cost base. It is simple to initiate. Just make sure that you do not write a naked call; otherwise, you’d be exposed to unnecessary risk.
Let’s take a look at Cisco Systems, Inc. (NASDAQ/CSCO) and assume that you own 1,000 shares at a cost base of $15.00 per share. You are already up $1.75 a share, based on the current market price of $16.75 as of May 19.
Now, say that you continue to be long-term positive on Cisco, but at the same time, you feel that the stock may pause or move lower over the next quarter.
There are several strategies at your disposal. You can sit on the position and wait for the stock to rise. The problem is that this is an inefficient use of capital, in my view.
So, why not make your capital work for you? It’s much easier than you think, and it represents a win-win situation. The process involves writing covered calls on your holding of 1,000 shares of Cisco. For every board lot (100 shares) of Cisco, for example, one call option may be written.
Covered-call writing is straightforward, low risk, a generator of premium income and guarantees a selling price for the stock. Don’t write a covered call if you do not wish to lose the stock due to a possible exercise from the call holder.
Let’s say that you are short-term neutral on Cisco and believe that the stock may have limited upside potential prior to August 2011. What’s the next step?
Given this, you could generate some premium income by writing calls on your 1,000 shares of Cisco. By writing the calls, you are, in turn, legally obligated to deliver your 1,000 shares of Cisco at the predetermined strike price if exercised and if assigned to you.
Here are the mechanics: you own 1,000 shares of Cisco and decide to write 10 out-of-the-money (OTM) Cisco August $18.00 call-option contracts (OTM since strike price is greater than market price) at $37.00 per contract, or $370.00 for the 10 contracts. This is the risk premium that you get for assuming the risk, and it is yours to keep whether or not the call options are exercised.
The strike price selected in call writing should be what you should feel comfortable selling the stock at if it were to be exercised. If the strike price was set too low, it would have a higher probability of being exercised, and you would lose your shares—perhaps at a lower price than you would want. Be careful about this. Conversely, setting a lower strike price translates into higher premiums for you. The decision ultimately depends on your view of the market.
The bottom line is that you need to be comfortable selling your shares, which, in this case, is at the strike of $18.00. Say that this happens—you would make $3.00 on the stock plus $0.37 for the premium for a return of $3.37 on the base cost of $15.00, for a return of 22.5%. The downside, of course, is that you lose the stock—especially if it advances above $18.00. This is a valid risk, as you do not want to be taken out early and miss out on any potential upside gains. You could always set the strike price higher.
Each situation is different, so be careful when doing covered-call writing. Look for stocks that look to be trading in a tight range, and set the strike just above the resistance level.