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What do you think of when you hear the term "perfect world?" If you're like a growing number of Chinese Internet users, the term "perfect world" brings to mind the popular online game of the same name.
Perfect World (NASDAQ: PWRD) is also the name of the company that creates and manages these games. The company specializes in massively multi-player online role playing games (MMORPGs). PWRD has a wide assortment of these games, covering a broad range of styles.
The majority of these online games are available to users for free. However, Perfect World then offers countless bonus materials (such as a particular weapon or functionality within a game), which gamers can purchase. The business model works well as users become hooked on the game and then become a reliable revenue source as they continue their quest.
One of Perfect World's strongest assets is its development platform. This proprietary program allows company developers to quickly and efficiently create high-quality games. The platform enables very realistic graphics, along with properly functioning physical properties such as gravity and light. Higher-quality games naturally lead to more engaged and loyal users.
Over the past few quarters, Perfect World has been working hard on the development side, creating new versions of its popular games, along with brand new titles that will launch in the next few months. Also, the company has been expanding into the U.S. and Europe with versions of its games that use English, French and German languages.
The focus on development has come with a short-term cost. Perfect World has pulled back on some of its promotion initiatives, and sales have declined. The company is still very profitable, but has been focusing on long-term growth rather than short-term metrics.
As a result, the stock price performance has been somewhat disappointing over the past year. But late this spring, shares began trading higher as investors anticipate the new product launches. The stock should continue to trade higher, and the option premiums are also inflated because of the volatility.
Today, we have the chance to set up a covered call position that can generate 81% a year on this high-growth Chinese Internet company.
PWRD Covered Call Strategy
PWRD is currently trading near $17 after its recent rally. I want us to buy the stock in 100-share lots, and then sell the July $17 calls against the position. You should be able to sell these calls for $1.10 per share. Remember, we sell one contract for every 100 shares of stock.
Between our stock buy price of $17 and our option selling price of $1.10, our net cost per share will be $15.90. Of course, your price may be a bit higher or lower depending on how the stock is trading, but your net cost should be very close to this level.
By selling the July $17 calls, we are obligated to sell our stock at $17 if PWRD closes above this price on the expiration date. These option contracts will expire on July 19, so we have 31 days until expiration.
Assuming the stock trades higher and we are required to sell our shares, we will realize a $1.10 per-share profit on this trade. That represents a 6.9% gain over a 31-day period. On a yearly basis, if we were able to continue to set up trades like this, we would realize an 81% full-year gain.
If Perfect World winds up pulling back, we're still in a pretty good spot. Remember, our net cost for the stock is near $15.90 per share, so PWRD can pull back a bit and we could still be sitting on a gain. Also, if the calls expire, we have the option of selling more contracts against the position (possibly the August or September calls).
Considering the strong advance PWRD has had in the past month, this trade is a bit more speculative. There is no guarantee that PWRD will not pull back materially, especially if the new product launches turn out to be disappointing.
However, it has been my experience that when a growth stock like PWRD makes a sharp move like this, it indicates demand from institutional investors. That demand is not likely to go away overnight, and I expect the overall trend for this stock to continue to be bullish.
I'd love to hear what you think of this trade. Are you invested in any Chinese growth stocks right now? Would you like to see more niche trades like this that help you generate income while protecting your capital? Please send your email to Editors@ProfitableTrading.com and mention this article on covered call writing.
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