August 5, 2013 - Let CVS Help You Practice Safe Options Trading
Earnings season is winding down and most of the big companies that report on-cycle have already turned in their quarterly report cards. Of the big names yet to weight in, CVS (CVS) is likely to have one of the best quarters.
In addition to the company's retail drug stores, it is among the largest pharmacy benefit managers in the country which is a business that should grow as more people get insurance under the Patient Protection and Affordable Care Act.
That's just one of a number of reasons to like CVS, more reasons can be found here and in this week's other Analyst Insight articles. My article this week is going to look at one popular options strategy, and suggest a better one.
Perhaps the most-used option strategy is to purchase a call. This strategy puts a relatively small amount of money at risk and stands to gain if the stock rises. It may not always be a winning strategy, but amount at risk can be relatively small compared to the potential gains. At InvestorsObserver, we compare this strategy to buying lottery tickets. The chances of a huge payoff are slim, but you're not risking that much either.
You could of course get very rich if you could accurately predict the lottery. The same is true with buying calls, if you could be certain that a stock was going up, call buying would be the perfect strategy.
Since I can't be sure exactly what a given stock is going to do, I like to use a slightly different strategy, a bull-call debit spread. I'll still buy a call, but I'm going to sell another call, lowering the cost to enter the trade and increasing the likelihood of turning a profit.
For CVS, a November $60 call is effectively at the money. If you were to buy this call, for $3.70, you would need the stock to rise to $63.70 just to break even. Anything above $63.70 would be a profit.
In a debit spread, I would buy that same call, but also sell a November $65 call. This lowers the cost of this trade to $2.50 and lowers the breakeven point to $62.50.
I now need the stock to rise by less than 1% before I start to profit, compared to an increase of 2.7% needed just to break even on the long call. A 1% increase seems a lot more likely than a 2.7% increase, making this trade more likely to end up a winner.
Chart courtesy of stockcharts.com
The sold call does cap the upside of this trade. The most I can make here is $2.50 per share, which happens if the stock rises at least 5% and passes $65. That would be good for a 100% return in a little over 100 days, which gives this trade a potential profit of 354.37% on an annualized basis (for comparison purposes only). That seems pretty good to me.
To get a 100% return on the bought call alone, the stock would have to go to $67.40, an 8% increase. That isn't impossible, but even with all that it has going for it, a big well established company like CVS doesn't make a lot of 8% moves.