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Julian Close's Insights

InvestorsObserver
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Julian Close
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January 26, 2015 - Starbucks: America's Drug Dealer

Starbuck's has us. It has us as its prisoners, its possessions and its playthings. And it has us perfectly, for we express little if any desire to escape. To the extent we acknowledge that it has us, it is, as here, with joy and not despair. It has been more than a year since my last Starbuck's trade, and clearly, it has been too long. Here's what I had to say about Starbucks 15 months ago:

"Starbucks is the largest, most successful coffee franchise on the planet, and there is no close second. It is also one of the most visible companies in the world, as its stores do best where human traffic is highest; there are, for example, 171 Starbucks locations in Manhattan. The brand is as much a part of America as Coca-Cola or McDonalds, despite being much younger."

Simply bump the number of Starbucks in Manhattan to 212, and the same words hold true today. Two things have happened recently to reignite my interest in the company. First, a simply insane number of Americans gave each other Starbucks gift cards for the holidays, which makes a great deal of sense. Since everyone goes to Starbucks, a Starbucks gift card is as good as cash, but with the added touch that it forgives/induces loved ones to go out and get themselves hopped up on sugar and caffeine.

Second, the Street heard Starbucks Corp's fiscal first quarter earnings report this morning, and even for a company with such a long history of success, it was a good one. Gushing analysts at Wells Fargo described the earnings as "grande," and the outlook "venti."

And that means the prospects for a successful trade using an out-of-the-money covered call strategy are excellent.

Let's look at the numbers. To make this trade, buy SBUX stock for $88.59 per share (100 shares, or scale as appropriate). At the same time sell one contract (100 shares worth) of the SBUX Jul 90 call for not less than $3.60 per share. Your initial $88.59 per share debit is offset by a $3.60 per share credit, making your break-even point $84.99 per share. If SBUX stock is trading at or above $90 per share on the day the option expires (07/17/15), your position is assigned, which means the market exercises the option to buy SBUX stock from you at $90 per share. Your target profit, therefore, is the exit price of $90 per share, minus your break-even cost of $84.99 per share, or $5.01 per share ($501, on a typical 100 share trade.)

But wait, there is more to this story. While the date has not yet been announced, the company will surely pay two dividends during the trade period. The ex-div dates will very likely be in early February and early May, and will be of approximately $0.32 per share. On either of those dates, the stock may be assigned early, which would mean you will receive the target profit (plus one dividend, if you've made it to May) but in less than the 175 days targeted by the trade.

If the trade works as hoped, the stock price will be above the strike price on expiration day, and the position will be assigned then. In that case, your profit, including the dividends, will be $5.65, a return of 6.6% over 175 days, making your annualized return (for comparison purposes only) 13.9%.

Chart courtesy of stockcharts.com

Here are your risks: if the stock price does not rise as high as the strike price, it will not be assigned, at which point, the call you sold will expire worthless, though as long as the stock hasn't fallen below your break-even point (which, by then, will have been lowered further by the dividends ? to $84.35 per share in this case), you still have a profitable trade. The difference between your buy price of $88.59 per share and your eventual breakeven cost of $84.35 per share is $4.24 per share, or 4.8%. That's your downside protection. And if the very worst should happen, and the stock falls below your breakeven cost, you'll still own a great stock, and your loss will always be less than if you had bought the stock without selling the call.

You may be noticing, at this point, that none of those outcomes are actually bad. That's exactly why this sort of trade is so popular with wealthy and institutional investors ? all investing may be likened to gambling, but when you write covered calls, it's like being the house. This trade is appropriate for investors with diverse portfolios who are willing to accept market-level risks.


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