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IBM and Google Covered Calls
The Smart Profits Report: Issue # 284
Friday, February 17, 2006
IBM and Google Covered Calls: Tracking These 2 Giants For An Income Jolt
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
With the baby boom generation entering its retirement years and interest rates at historically low levels, more people are looking at selling covered calls as a way to produce income. That’s smart. But many investors know little about how to get the job done.
So, let’s back up a bit. Covered call writing is a strategy in which an investor writes (sells) a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call contract, the strategy is commonly referred to as a “buy-write.” If the shares are already held from a previous purchase, it is commonly referred to as an “overwrite.”
Either way, the stock is usually held in the same brokerage account from which the investor sells the call, and “covers” the obligation by owning the underlying stock.
Writing a covered call is most often used when the investor believes that the stock is almost fully valued and could stay that way for the lifetime of the call contract. The investor wants to generate additional income from shares of the underlying stock, and/or provide limited protection against a decline in underlying stock.
Let’s look at a potential covered call situation on IBM (NYSE: IBM), and a Google (Nasdaq: GOOG) trade that produced the cash flow so many income investors are seeking.
Two Indicators Signaling A Pullback
When it comes to timing covered calls, the two most important risks include 1) getting your stock called away, and 2) experiencing a larger-than-expected drop in the underlying stock once the call is written.
When you enter a long position, you should always have a stop loss price in mind. That applies to a covered call position, as well. If the underlying stock falls below your stop loss level, the stock should be sold and the call bought back. The second risk does not apply to all investors, because some employ a call writing strategy in hopes of having the stock called away, increasing their short-term return.
However, long-term investors with a low cost basis on the underlying stocks who write options to produce income, don’t want their stock called away because it would trigger a taxable event. If you are in this category, (or are just looking to buy some protective put options), there are a couple of technical analysis tools that can help you time your option strategy. Let’s look below at covered call scenarios with IBM and Google…
Charting IBM Covered Calls
Below is a weekly chart of IBM (please keep in mind this is an example, not a recommendation) with Bollinger Bands overlaid on the upper half of the chart (two grey lines) and Slow Stochastics on the bottom of the chart.
Copyright (c)1999-2006 by StockCharts.com Inc., Redmond Washington.
All rights reserved. http://www.stockcharts.com
Stochastics and Bollinger Bands are two technical indicators that show both overbought and oversold conditions. We use these indicators because when you’re writing covered calls, the best time to act is when the underlying stock gets into an overbought situation.
When the stochastics trade above 89, or the stock trades near the upper Bollinger band, the stock is considered overbought. When both occur simultaneously, as indicated by the red marks, the odds favor a correction from that area. The jury is still out on the latest overbought situation here, but the previous two led to selloffs between 15% and 30%.
How We Charted the Google Covered Call Play
A few of my clients who are long-term investors own Google. They recently used this strategy to protect some of their unrealized gains. In mid-January, the stochastics rose above 89, and Google’s stock price hit the upper Bollinger Bands on both the daily and weekly charts. That raised the caution flag, and we prepared for a pullback…see the chart below:
Copyright (c)1999-2006 by StockCharts.com Inc., Redmond Washington.
All rights reserved. http://www.stockcharts.com
As you can see in the daily chart above, on January 19 the stock closed at $436 (below the blue line). Predicting the near-term pullback, we sold the March $440 calls for more than $21.
And it paid off. Google indeed came down sharply, and we recently bought back the covered calls for about $1. That reduced my clients’ cost basis by $20. Multiply that by the number of contracts written, and you’re talking about real money.
Today’s Smart Profits Cribsheet
- In a future Smart Profits Report, I’ll show you a different call writing strategy that will protect your position from a larger-than-expected drop in the underlying security. Stay tuned…
- Check out the Smart Profits Glossary for definitions on option terms like “covered calls” and “option chains.”
- Bollinger Bands and Slow Stochastics are valuable - and pretty common - technical indicators that traders rely on to generate handsome profits. If you do not have access to a charting service, these tools can be located at www.StockCharts.com.
Good Trading,
Jim
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Related Articles:
- Covered Calls: Getting Cash for Stocks You Already Own
- Covered Calls: How to Beat Stocks with Less Risk
- How to Enjoy Guaranteed Monthly Income With Options
