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Today is options expiration for April contracts. Unless something unexpected happens, we are going to recognize the maximum gain for both of the April covered call setups that I recommended roughly a month ago. Heading into the last trading day before expiration, we own Big Lots (NYSE: BIG) and Family Dollar Stores (NYSE: FDO).
As of Thursday's close, BIG was trading at $35.87, and we have the April $35 calls sold against the position. The premium from selling the calls lowered our cost basis on the stock to $33.87. Assuming BIG doesn't drop below $35 before the close, we will realize our maximum total profit of $1.13 per share -- representing a 30.7% annualized rate of return. Not too shabby, especially considering the turbulence in the overall market during the past several weeks.
For FDO, our returns are even better. We took a little more risk on this trade, selling call contracts that were out of the money to hedge the position. We bought the stock near $58.96, and it had rallied to $61.66 at Thursday's close. We sold the April $60 calls against the position, so we can be pretty confident that the stock will be assigned, obligating us to sell at $60.
With FDO trading higher, we will recognize a total gain of roughly $2.54 per share ($1.04 in capital gains plus the $1.50 in options premium brought in). That nets out to a 49% annualized rate of return, compensating us well for the additional risk we took.
With both of these positions being wiped off the books, I'm interested in taking another swing at the discount retail sector.
A New 33% Annualized Setup for Big Lots
With the broader stock market becoming more volatile during the past week, I've been particularly impressed with the action in Big Lots. As you can see in the chart below, BIG has hovered near its recent highs after breaking out of a healthy basing pattern.
On the fundamental side, I like BIG because of the space that it fills in the retail area. At this point, the company is performing well, with profits steadily growing. And if the economic picture turns south, as I think it very well might, there will be more consumers looking for bargain prices and shopping at Big Lots. So, over the next month, I think there is a very high probability that BIG holds up well, and an outside chance that it rallies sharply.
For our trade setup today, I want to buy BIG in 100-share lots and sell the May $35 calls against the position.
BIG opened Friday at $35.99, and the calls were selling for about $1.85. This means that our net cost is $34.14 -- giving us a significant amount of protection if BIG does in fact back off a bit.
Of course, selling the $35 calls obligates us to sell our stock at $35, assuming the stock remains above $35 through May expiration. Selling the stock at $35, against our net cost of $34.14 to put the position on, we can expect to realize a profit of $0.86 per share.
This profit represents a return of 2.52% over a 28-day period. On an annualized basis, the return nets out to 32.8%. Once again, we can see how consistently following a covered call strategy can do wonders for your long-term investment gains.
A Good Reason to Use Your IRA for Covered Calls
Since this is tax week in the United States, I thought I would quickly weigh in on one of the most efficient ways to generate returns on your investment capital.
One argument some investors have against the covered call strategy is that investment gains are typically classified as "short-term trading gains," and thus taxed at a higher rate.
Of course, I'd rather be taxed at a higher rate on a 25% to 35% investment program, than recognizing long-term gains on a strategy that has lower returns and more risk. But there is another way that you can benefit from the covered call strategy while avoiding the higher tax rates associated with short-term trading.
If you use your IRA account (either a traditional IRA or a Roth IRA) to follow our covered call trades, you will actually get the best of both worlds -- lower tax liability and higher returns.
For Roth IRAs, there is no future tax liability because all of the taxes have been paid before the capital was put into the retirement account. For traditional IRAs, the gains will still be taxed when capital is pulled out of the account, but there is no differentiation between long-term and short-term trading strategies.
Both traditional and Roth IRAs allow you to buy stock and sell calls against the position, giving you an opportunity to generate either tax-free or tax-deferred gains on this profitable strategy.
As always, please let me know how you are doing with this strategy. Send your emails to Editors@ProfitableTrading.com. And I'll be back next week with additional covered call recommendations.
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