Take advantage of positive stock events to generate income

Income seekers are always looking for new ways to generate cash into their accounts. One tried and true method that is particularly suited for bull markets is that of the covered call. For those of you unfamiliar with this strategy, it consists of selling a call option against underlying stock held long. [For those of you familiar with the covered call strategy, you can skip to the bottom.]

Covered call strategy overview
There are two ways to estimate your expected covered call return. The first is the assigned yield which occurs when the stock trades above the strike price of the option and is called away (assigned). In this instance, your return on investment (ROI) is the following: [(strike price – stock purchase price) + option sale price]/stock purchase price.

The other return is called the unassigned yield. If the price of your stock trades below the strike price of your sold option at the option expiration date, you will retain possession of your stock and your ROI will then be given by the following: option sale price/stock purchase price.

You can see that the unassigned yield will always be lower than the assigned yield, but the trade-off is that in the former case you get to keep your stock and in the latter case you lose it. So which approach is better?

That depends on your point of view. Most folks looking for income want to achieve the assigned yield, and the sooner the stock is called away, the better. Why? Because they can immediately put that profit to work by writing another covered call, hopefully while the market is still hot.

On the other side of the coin, those looking for stock appreciation will probably not want their stock called away. If this is so, then a covered call strategy is working against them. However, if your stock has enjoyed a long run-up and you’re concerned a correction is overdue, then writing a covered call offers a bit of downside protection. How much? The calculation is exactly the same as for the unassigned yield shown above. Your break-even point, i.e., the point below which you start losing money, is the stock purchase price less the option sale price.

Covered call opportunities
Income investors seeking the maximum assigned return should be looking for those stocks with positive momentum. Some of the best picks are the market darlings.

The problem with many market darlings is that can be expensive. Look at the prices of Apple and Google. To set up a one-contract covered call strategy with either of them would cost you $35k and $62k respectively–you’d have to be Daddy Warbucks to set up these trades!

A better way is to seek out the rising stars that are still affordable.  How can you spot a rising star?  Look for those companies that have recently been recipients of good news such as analyst upgrades (the more analysts piling on, the better), a new product line, better than expected earnings, rising same-store sales, a successful drug trial, or an upgrade in forecasted earnings and revenues.

All of these are proven stock movers, and the more of these a company can get, the faster its stock will appreciate. Typically, analysts will upgrade a stock if the company blows out earnings and guides earnings per share and revenues higher. But analysts tend to jump on the train after it’s left the station, so in some cases an upgrade isn’t very meaningful.

Covered calls on raised earnings
I like covered calls on upgraded earnings revisions, especially if the stock has been performing well before the announcement. That means that investors have confidence in the health of the company. Here are four stocks that were rallying before their companies raised guidance. [All of these stocks can be found in the Subscriber Services.  There are currently 140 stocks in the earnings upgrade database.]

Cirrus Logic (CRUS): Chip maker Cirrus Logic has been a media darling for a while (it’s one of the Big Booyah’s favorites). The stock broke out of a five month base on Jan. 27 when it announced that it beat earnings estimates and upped Q4 revenues from $85.61M to $88-$94M.

Skilled Healthcare (SKH): This nursing home operator raised its FY11 outlook on January 6th causing the stock to pop by 14%. The company guided its EPS higher by a whopping 34-45% and raised revenues fron $857M to $880-$900M. It will report earnings on February 15th.

Skyworks Solutions (SWKS): Chip and electronic subsystems maker Skyworks Solutions has been a stellar performer, steadily rising from a low of $4 two years ago to its current price of $35—that’s a 775% price appreciation! If you’ve been holding this stock for a while, you may want to take a few of your own chips off the table as it’s now trading at a trailing P/E of 38 which is much higher than its industry P/E of 18. The good thing about the covered call strategy is that it offers you some downside protection, just in case the stock decides to take a breather.

Teradyne (TER): Automatic test equipment maker, Teradyne, is the third member of this covered call group from the semiconductor industry. It’s system-on-a-chip (SoC) test rig is used in mobile phone technology which is fueling its explosive sales growth. On January 26th, the company upped Q1 guidance by an entire quantum level, raising EPS from $0.19 to $0.33-$0.39 and revenues from $295.44M to $350-$375M. The stock gapped up 11% on the news and has been rising since.

Here’s a table showing the assigned and unassigned returns for some February and March near-the-money covered calls.

Note: Although the open interest on the SKH March call is low, there has been decent volume on it so it’s worth putting in a limit order.

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