Welcome back to my weekly column with the International Business Times.
It has been another exciting week in the US market with optimistic economic data released almost every day. However, there continues to sentiment that the market is overbought and that there ought to be a pullback and as a result of this sentiment, we have seen decreasing trading volume over the last couple of weeks.
Despite the sentiment that the market is overbought, there is widespread optimism about the future of many stocks and one of them is traded on the NYSE with the ticker NYX. Jim Cramer said on CNBC’s Mad Money last Friday that NYX “is a solid buy.” Now, that’s an extremely strong statement to make on a stock. Jim Cramer is citing long term strength for NYX when he expects IPOs to come back with the economic recovery. He also said that NYX has strong business fundamentals and that “business is up”.
Indeed, NYX is a company with strong fundamentals and it pays a 4% annual dividend. This makes NYX shares great to own since they offer long term growth and a steady income.
But what if there is a correction in NYX after I buy it?
First of all, since NYX is going to be a long term investment, it really doesn’t matter if it has a pullback or not, as long as it’s price appreciates in the long term. But, what if you really hate to see your account value go down in the short term? What if you want to make a profit even if NYX goes down? Can we solve this problem using options?
The good news is that we can, and it is really simple. We can use what options traders call a Covered Call.
I am sure most of you heard about the Covered Call before but what exactly does it do? In a Covered Call, all you have to do is to write out of the money call options on stocks that you own. These short call options serve to hedge against downside risk in the amount that they are written for and also they also produce a residual income as long as they do not exceed the strike price of the written calls.
In the case of NYX which traded at $29.83 on Fridays close, you could write the June $31 Call options bidding at $0.62 for a static return of 2% in less than a month or if you think the pullback is imminent, you could even write the June $30 Call options bidding at $1.00 for a static return of 3.3%. Static return is the return you get if the stock remained stagnant through June options expiration. What those call options do apart from giving you a residual income if NYX remained stagnant or rises to less than $31 or $30, is that they also grant downside protection. The June $30 Call options will grant a $1.00 downside protection to NYX, which means that if NYX drops to 28.83 by June expiration, your account value would not have dropped at all! See how this works? If NYX continues to rally, you could either allow it to get called at the strike price for a profit or if you already think it will not pullback, simply close out the short call options or continue holding the stock for the long term.
See how the Covered Call allows you to hedge against short term pullbacks and also generate a monthly residual income? For more information on covered calls, please refer to my tutorial on Covered Calls
Lets now take a look on our previous options plays.
DRYS retreated 13.55% last week on talks of a slowdown in the shipping industry and Jim Cramer’s obvious dislike for their CEO. However, DRYS still managed to put in a new weekly high, suggesting that strength still exists in the stock. It’s Sep 7.5/11 Bull Call Spread is now worth $0.95, which is lower than last week’s $1.05 but still higher than our initial debit of $0.90. There are 3 months more to go with this position, and if you think DRYS and the shipping industry are going down the drain, you could sell the Sep 7.5 Call options and hold on to the short Sep 11 Call options and make the $0.65 in profit as long as DRYS closes below $11 by Sep expiration. The risk of this is that you would run into an unlimited loss should DRYS stage a strong rally past $11. This is why you must set a contingent order to close the position when DRYS exceeds $11. Another thing to take note is that margin is required to hold short options positions, so this may not be executable by everyone.
EEM gained 1.11%, closing at $33.61 last Friday. Its 3:1 September 33/37 Call Ratio Spread is now worth a credit of $0.87 versus a credit of $0.61 when we first covered the trade last week. This is due to the out of the money $37 call options gaining in terms of extrinsic value faster than the $33 call options. Regardless of how much the $37 call options gain, as long as EEM remains below $37 by September Expiration, the extrinsic value goes into your pocket.
Disclaimer : Neither I nor Masters 'O' Equity or Optiontradingpedia.com and any of the staff, own any shares in DRYS nor hold the above mentioned options trading position. The above article uses closing prices on 5 June 2009. Actual prices on Monday opening may differ. This article is for education purpose only and should not be taken as individual investment recommendation. Options trading is not suitable for everyone and advise should be sought from your local financial adviser.