Jan 20, 2010

January 19th, 2010

TRADE OF THE WEEK

We start with a simple trade called the “buy-write.”  The purpose of this trade is to capture premium income from the SALE of a “covered” call.

This trade is typically used when you already own the stock, especially a stock that pays a reasonable dividend.  But in this example I am assuming that you do not already own the stock.

Step one: buy 1000 share of Medtronic (MDT) at today’s price, $45.61, paying approximately $45, 700 with commissions.

Step two: sell 10 calls of MDT May 49 at $1.20.  Take in $1,200.

I would usually place this order as a “simultaneous trade” with my broker so that both trades are done at the same time.

Why do I like this trade:  MDT pays a dividend at this price of about 1.8%.  I think this is a good company, likely to go up slightly over the rest of 2010, and not likely to go down by very much, if at all.  The current dividend is $.82, or $820 per year for 1000 shares.  1.8% is not much of a return on tying up $45,000.  But if I add the $1,200 from the option premium, my return goes up to $2,000 per year, which is over 5% yield on my money—and that’s not bad.

What can happen and what is the risk?  What I expect to happen is that the stock stays between $45 and $48 during this year, and I will keep writing calls against it as each one expires.  If I write calls only twice during the year (and I might get three times) at about the same premium, I might capture $2,400 plus the $820 dividend, for a total of over $3,000 after commissions, and end up with 7-8% return on my investment.  I might get as much as a 10% return.

If the stock goes over $49 while I have the option in place, I will let the buyer take my stock at $49 and I get to keep the premium plus make a $3.40 profit per share on the stock—a bonanza result.

If the stock goes below $45, and I sell it, I will lose money on this trade.  But I wouldn’t plan to sell it. I would plan to keep writing calls against it for dividend and option premium income, and hold the stock for the future, because I have confidence in the company.

Mlh Jan 20, 2010