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Mar 12 2010 An idea for a bull call spread from
a reader and my answer:
READER'S
QUESTION: Hello; I
was thinking of using the same strategy that you use
on
XOM on Kraft. BULL CALL
SPREAD I would (BTO) Long 20 Jan 12 Call and (STO)
Short 31 Sep 10 Call. Your thoughts on this play
please.
MY ANSWER:
It
all comes down to your objective, level of comfort and
outlook on the stock. On March 5 2009 Kraft made a new low
of 20.81. That’s been the low for more than 10 years. Seems
like you may have found a good strike. $30.00 doesn’t seem
unreasonable to me. Remember these are just my opinions.
Nothing discussed is recommendations or financial advice.
Investing can result in large losses and spreads can and
often do end up with large losses.
OUTCOME A) If the spread works in your favor:
My figures are based on Mar 12 2010 with Kraft
trading at 29.39 I based this on 5 contracts - no
commission taken into account.
Jan $20 call is trading at 9.45 ASK
Sep $30 call is trading at 1.12 BID
Original cost of Jan 2011 $20 calls 9.45 X 5
contracts = (4725.00)
Exercise shares of Jan 2011 $20 calls 20 X 5
contracts = (10000.00)
Exercise shares of Sep 2010 $30 calls 30 X 5
contracts = 15000.00
Income from STO Sep 2010 $30 calls 1.12 X 5
contracts- 560.00
Total profit = $835.00
Based on original investment of $4725 - $835.00
profit = 17.67% a nice return for this 6 month
trade. If you want to go out to January with the STO
$30.00 calls they are 1.47 bid which would bring the
profit to $1010 or 21.3% for 10 months
6 months = 17.67% or 2.94% / month
10 months = 21.3%
or 2.13%/month
So the 6 month trade is better.
Summation: Just need $4165 (4725 less 560) to
invest; the all time low for Kraft was 21.80 in the
past 10 years; You know up front your loss should
the stock fall below your break even. You
cannot lose more than this'; You can always buy back
the trade and roll forward into another year; If the
stock moves up, you can close part of the trade -
for example if you have 5 contracts you can exercise
early; or buy the 5 Sep 30 calls back but close just
3 of the Jan 20 calls and try to gain more income
from the rise in the stock – this can be risky
though if the stock pulls back. You could easily
move into a loss situation by trying this.
OUTCOME B) TRADE DOES NOT WORK OUT
Your break even is $28.33. Your total loss cannot
exceed $4165.00 on this spread. You can always close
early to try to reduce the cost. You can roll your
positions into another year. As you have sold the
Sept 30 calls, if by Sept the stock is not at 30,
you still can do one more call sell into January to
try to recoup any loss.
COMPARISON TO JUST BUYING THE SHARES
If you bought 500 shares today at $29.39 (remember
no commissions taken into account)
Cost 500 X 29.39 = $14,695.00
Possible Dividends received - (Mar, Jun, Sep,
Dec) - $580.00
STO 5 covered calls Sep 2010 $30.00 X 1.12 = $560.00
Total capital invested: - $13555.00
Break even = $27.11
Sell at $30.00 = 15,000.00
Profit = 1445.00 = 9.8% (1445.00/14695.00)
ADVANTAGES:
Lower break-even at $27.11; If you qualify for the
dividend tax credit (we have this in Canada, I don’t
know about the USA) most of the dividends will be
taxed at a low rate; Should the stock pull back and
not close above 30.00 by Sept 2010 you can continue
to sell covered calls if you like; While with
every trade there is a break-even (27.11) , when you
own the stock you can continue to sell calls against
it even if it falls below your break-even allowing
you to reduce your cost basis; Kraft is a
strong stock presently with a substantial dividend.
DISADVANTAGE:
While you can sell covered calls repeatedly, even
below your break-even, you may still have a larger
loss than $4165.00. As well it could take years to
recover if the stock fell to perhaps its low again
at 21.80. |
