Market Overview

Tempur-Pedic (TPX) Covered Call Play

The current market has been unsettled for traders and investors making some option strategies more difficult to implement than others. Fortunately a covered call can be very flexible. A covered call is generally used to generate additional income for a stock position but it can also partially protect a solid stock in turbulent markets. It's not a Danica Patrick, high-speed trade; it's more conservative and prime for stable stocks.

Let's take a minute to learn to trade covered calls. An example of a covered call is to buy stock or already own stock and sell a call option against the stock position. The key is to find a stock whose company has solid fundamentals and doesn't have an upcoming earnings report in the near future. Let's see what looks good this week.

Tempur-Pedic International Inc. (TPX) looks like a solid candidate. The company makes luxury mattresses. TPX just announced earnings on July 26th and said that is second-quarter profit jumped more than 59% beating Wall Street expectations.

The theory on this covered call trade example is this:

TPX has strong fundamentals and just increased its full-year financial outlook. The stock pulled back some in the beginning of June this year but ever since it has climbed higher or channeled sideways. September expiration gives the trade a little more than 40 days to go until expiration. Just because the market has been extremely volatile lately, this TPX covered call trade idea is structured more for protecting the stock in case it goes sideways or takes a dip down, but will still enhance the trade's return if the stock never does.

Tempur-Pedic International Inc. (TPX) - $69.20

Example: Buy 100 shares of TPX @ $69.20 and sell September 70 call @ 3.50

Cost of the stock: 100 X $69.20 = $6,920 debit

Premium received: 100 X $3.50 = $350 credit

Maximum profit: $430 that's $80 (70 – 69.20 X 100) from the stock and $350 from the premium received if TPX finishes at or above $70 @ September expiration.

Breakeven: If TPX finishes at $65.70 (69.20 – 3.50) @ September expiration.

Maximum loss: $6,570 if TPX goes to $0 @ expiration.

The main objective for a covered call strategy is for the stock to rise up to the sold call's strike price which in this case is $70. The stock moves up the maximum amount with being called away and the sold call expires worthless.

The breakeven point on this covered call was structured to be at a nice area of support, which is in the $65 area.

As always if the stock moves past $70 and looks like it's not going to slow down, then the call that was previously sold (September 70) can be bought back and a higher strike can be sold against the position. This will allow the stock to remain in the portfolio and also give the position a chance to increase its return. Remember no matter how far the stock goes beyond $70 at expiration, the maximum profit is capped because of the call that was sold at the 70 strike. If for some reason TPX takes a dive south below support at $65, the stock can be sold and the option can be bought back to reduce losses.

Every trade should have defined risk and loss parameters in place even if the trader or investor is just paper trading.

Dan Passarelli is an author and the founder of Market Taker Mentoring LLC, a personalized options education service. Dan has more than 17 years' experience in the options industry and has worked as both a floor trader

Posted-In: Long Ideas Options


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