3 Great Stocks for a Covered Call Strategy

Written by GSCR Staff   
Friday, 11 January 2013 12:34

Most retail investors and traders do not think of options when buying or selling stocks in the small cap space and there is generally lot of fear inappropriately associated with the word ‘options’.  The fact is that option strategies can be used in a very conservative way to generate income as well as incorporate some built in ‘discipline’ in your trading.

The most conservative option trade is the covered call.  For those not familiar or those needing a review here is what is involved simplest terms:

  • Buy 100 shares of stock XYZ
  • Sell 1 Call Contract of stock XYZ (1 contract = 100 shares of underlying security)

After the transaction, the investor will own the stock and generate the income of the trade price of the option contract.  One crucial element to remember is that 1 contract equals 100 shares of the underlying stock.  So, the investor needs to buy 200 shares for 2 contracts, 300 for 3 contracts, etc. to cover the total number of call contracts.  Selling uncovered calls is the riskiest proposition there is in options trading, and more than likely would not even be executed with the majority of online trading retail accounts.

The simple strategy we are using today is generating income from the call sale while at the same time implementing some profit-taking discipline also.  What do we mean by that?  An investor sells ‘out of the money’ calls at a strike price equivalent to what he/she is willing to take profits and sell the underlying security.  This mechanism is automatically in place, as the buyer of the call could ‘exercise’ or buy the stock from the contract if it moves above the strike, which is in essence your target price.  As a result, the worst-case scenario is that you sell the stock at your low-end target price and the best-case scenario is that you generate income from the call option sale, enhancing your return on investment.

Some of the most popular options available in the small cap space tend to be in the bio-tech, oil and gas exploration, and mineral and metals mining industries.  We used our screeners to find one stock from each of these sectors in the small cap space that looked the most attractive to execute a covered call strategy.

Here are the criteria we used to pick these three stocks:  Figure 1 shows the results and summary.

  • Stock price under $5
  • Momentum upward with at least 25% increase off of 52-week low
  • Technical Analysis illustrating short, intermediate, and long term,  bullish indication or better (Figures 2-4)
  • Consensus Analyst Opinion of Buy or Better
  • Out-of-the-money strike price at least 6 months from expiration and above $50 premium for sale.  (Remember premium from sale = ask price x 100)

 

Figure 1: Summary Information for 3 Stocks

A quick observation can be made that all of our strike prices are $5.00, and all are under their respective 1-year targets.  Remember, the stock price would have to rise above $5 before buyers would begin to exercise.  Additionally, if and when this exercise would happen, it does not necessarily mean that the contract(s) an individual holds will be exercised; it is the ‘luck of the draw’.  Additionally, you can always reverse the transaction by buying the same month and strike price call and selling the underlying shares to back out completely.

If the call contract you sold gets exercised, the 100 shares of the underlying stock you own are sold at the strike of $5, and that is what you make on sale. 

As an example, if you bought 100 shares of TC at $4.35, you will earn $65 from the sale of the stock, and $60 on the income from the sale of the call, for a total of $125 for the entire transaction. 

Remember, these trades are not free, so make sure you know how much your broker charges before you go charging ahead.  Below are some background and other relevant information in a summary for each profiled stock and related charts in figures 2 through 4.

NASDAQ-ARRY-$4.18:

Array BioPharma, Inc. was founded in 1998 and calls Boulder, CO its home.  Its main focus is on the discovery, development, and sale of small molecule drugs in the treatment of cancer patients in North America, Europe, and Asia.  Its ARRY-614 and ARRY-520 products, along with three other partnership products, are all expected to enter phase 3 or pivotal trials by the end of 2013.  Recently, the company received a credit extension out to June 2014 and October 2014 for its existing revolving credit and term loans. 

NASDAQ-MHR-$4.14:

Magnum Hunter Resources Corporation is involved in the acquisition, exploration, development, and production of crude oil, natural gas, and natural gas liquids in West Virginia, Ohio, Texas, Kentucky, and North Dakota.  The company was founded in 1997 in Houston.  Magnum Hunter has become a major player in the Marcellus and Utica shale discovery in Ohio, West Virginia, and Kentucky with over 2,000 wells in operation and 87,000 acres in that tri-state region.

NASDAQ-TC-$4.46:

Thomas Creek Metals Company, Inc. was founded in Denver in 2007 and is primarily engaged in the mining, milling, and sale of molybdenum products in the U.S. and Canada.  Molybdenum is used as an alloy in the production in various forms of steel and stainless steel for improvements necessary for corrosion, welding, and temperature resistance as examples.  The company also owns properties and is involved in silver, gold, copper, and zinc secondarily.  Additionally, Mt. Milligan, one of its gold and silver mines, will begin producing in 2013 in Q3 or Q4.

Figure 2: ARRY – 4 Month Technical Chart

(Source: Stockta.com)

Figure 3: MHR – 4 Month Technical Chart

(Source: Stockta.com)

Figure 4: TC – 4 Month Technical Chart

(Source: Stockta.com)

An option trading strategy still requires a little more risk and comfort level than the typical buying and selling of stocks.  However, conservative strategies exist that can really give you some ‘bang for your buck’ if you have the patience and appetite.  Disclosure: Goldman Small Cap Research analysts are neither long nor short these shares but may elect to purchase the stock within the next 48 hours.

 

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