In The Money Covered Call Earns 3.0%

This 1 Month Trade Can Earn 3.0% And Has 6% Downside Protection

Earlier  on July 7 I wrote about my Trade Anatomy showing how I earned 3% on Microsoft for a few days of work. While to me it wasn't much work, many investors find picking the moment to buy and sell based on technical indicators, tough to do.

For those investors here is a Microsoft stock trade that is perhaps much easier to put in place and possibly understand. Yesterday I bought 2000 shares of Microsoft Stock. Today I sold in the money covered calls for August 20 expiry which if I am exercised will earn about 3.0% or if I captured the August dividend 3.5%. If on the other hand the stock falls I have 6.45% downside protection. There is a lot to like about this investment.

Microsoft has had a nice run up after June 27. This was the first move where I earned 3%.

In order to earn another 3% in Microsoft stock, it would have to run up about another .80 cents from around $26.50. I believe Microsoft will move higher over time, but protecting my capital is also important. I could just buy some calls and hope they work out, but options are a wasting asset as they have an expiry day, which is why I enjoy selling options so much.

Instead looking at the chart, yesterday I noticed that even with all the selling of the past two days, Microsoft held up very well. Therefore in yesterday's weakness I bought 2000 shares at $26.42. The stock is trending sideways but staying about the mid-point of the Bollinger Band, which is a good sign. The 10 day is widening but beginning to show signs that the next move may be sideways in Microsoft stock.

After purchasing my shares on Tuesday Jul 12 2011, here is what I saw at the end of the day: The overbought condition is disappearing. Momentum is waning although the stock has not fallen much from $26.98, the high in the latest run up. MACD is also waning as it had higher readings a few days earlier and each day the divergence rating has been falling, but remains positive. Volume is now back to low. All of these signs indicate the latest run-up has stalled. As I believe Microsoft has more upside potential over the next few weeks or months, I would like to get into the stock and enjoy another decent return over the next four weeks and then move out.

I believe the downside to be probably around the $26.00 level in the short term should the NASDAQ take a tumble lower for a few sessions to a few weeks.

I don't believe the market is going to crash, but as I indicated in my market direction call last night RAZOR'S EDGE, July 12, I do believe the S&P500 could try to retest the 200 day moving average, although 1310 to 1300 marks good support right now. A move of the S&P to 1300, would pressure the NASDAQ and could push Microsoft back to $26.00 or about 1.6% lower. However a move below the 200 day moving average could see Microsoft back to perhaps $25.00.

I am, as you know a cautious bull, this year. Therefore protection is important as well. As I indicated last night in my market call, I believe there will be a bounce as selling was quite large on Monday. Today we got that bounce and options immediately moved higher. I zeroed in on the in the money covered call at the $25.00 and $26.00.  To mention of interest, the put values are lower as the market maker obviously feel the stock is in an uptrend and they are asking higher premiums for the calls. This is part of the reason I liked the In The Money Covered Calls for this trade.

I put in my offer to sell 10 calls for August 20, $25 strike for $2.10 and waited. With the morning jump I got filled at $2.12, which was just excellent. The extra 2 cents will pay the commission cost.

I put in my offer to sell 10 calls for August 20, $26 strike for $1.33 and was filled at $1.34. Interactive brokers is often just great at getting me the best fill they can and this time was no different.

Some investors would prefer the $27.00 which would provide a decent profit for August plus some capital gain. But at around .72 cents my protection would basically be a break even on the stock.

The $26 was compelling as it offered 3.5% return for the month, and 5% downside protection. The $25 earns 2.5% and has 7.9% protection. These are perfect for my strategy. Remember that I have already made 10% this year with my investments, and now I am just trying to earn that remaining 2% to meet my goal for 2012.

Here are the figures:

Total Capital At Risk - $52,847.00
Number of Shares - 2000
Covered Call Income Earned - $3421.00
Cost Basis in the stock - $52,847 - $3421.00 = $49,426.00 /2000 shares = $24.71

To see how the break-even price point measures up, below is the 1 year Microsoft Stock History chart from July 2010 to July 2011. $24.70 marks what I think is an excellent price point to end up in the stock should the trade not work out and the stock fall dramatically back in the next month.

On more thing to point out is the possibility of earning the August dividend. If the stock is above $26.00 I would think I would be exercised when the dividend is paid out, possibly around August 17th (X-Dividend Date last year). I could also if the trade is working and the stock is about $27.00, consider rolling the calls out to September if premiums warranted it which should then capture the August dividend..

SCENARIO 1: - Exercised August 20 at $25 and $26 strikes:

Trade will earn:
Original Capital invested - $52,847
Capital returned if exercised - $50980.00
Covered Call Income - $3421.00
Total Profit = $1554.00
Return = 2.9%

SCENARIO 1: With Dividend Income
Total Profit = $1874.00
Return = 3.5%

Meanwhile if the trade falters I can close the trade early and perhaps still have some profit, roll it out further or add the position to my overall Microsoft stock portfolio trade.

SUMMARY

This trade could be put in place by any investor with smaller capital and still earn a decent return. Perhaps 200 shares for August 25 and 200 for August 26. With volatility higher in Microsoft right now, call premiums are up as the stock is trending up and analysts are jumping back into Microsoft with some calling for the stock to head to $38.00 over the next few months.

I think such predictions should be ignored and instead for those investors interested in owning and benefiting from Microsoft Stock's latest uptrend, stay with in the money covered calls as long as premiums provide a decent return and I believe anything over 2% for a month is an excellent return. The whipsawing action of the NASDAQ provides these types of opportunities for those investors willing to take the plunge. I have a lot of confidence in Microsoft Stock and the company. It has been a favorite stock for 10 years and I am sure it will still be a favorite 10 years from now.