If the Fed follows through and reduces its bond purchase program (currently at $85 billion a month), interest rates will rise and stocks could come under pressure. We’ve already seen preliminary increases in interest rates, and the broader market is looking less stable by the day.
So what does that mean for us as covered call investors? Well, as I recently explained, our covered call strategy can be adjusted to be more aggressive during periods where risk is low, and more conservative during volatile periods.
In today’s environment, I want to pick stocks that have strong patterns and solid underlying businesses. I’m less likely to buy unproven growth stocks because these companies can be more vulnerable to unexpected declines. And I want to sell in-the-money options that do a better job of protecting our capital.
Taking a more conservative approach will cut down on our prospective returns a bit. But we can still expect to generate 20% to 30% a year by setting up covered call trades on healthy stocks that are trading with stable patterns.
Discount Retail Still Attractive
The discount retail group is still one of the better areas to be invested in today. We’ve already booked some solid returns on retailers that cater to budget-conscious consumers, and today we’re going to set up another covered call trade in this area.
Ross Stores, Inc. (NASDAQ:ROST) operates off-price retail apparel and home fashion stores, selling name-brand products that are overstocked at department stores. This allows the company to sell its merchandise at prices that are usually 20% to 60% below typical department store prices, offering consumers a tremendous value.
Ross Stores, Inc. (NASDAQ:ROST) currently has more than 1,100 stores across the U.S., and has a strong history of annual revenue and earnings growth. The company is expected to earn $3.89 per share this year, and analysts expect earnings to grow by more than 12% next year.
The off-price retail industry has been gaining market share from traditional retailers with the five largest off-price retailers increasing sales by 11% last year compared to a 4% increase for total national apparel stores.
Part of the reason off-price retailers have been successful is because of a structural shift in the employment environment. While the unemployment rate has been steadily dropping and jobs have become a bit easier to find, the new jobs that are being created pay significantly less than the jobs that were lost during the financial crisis.
So today, we have more consumers who do have jobs, but budgets are tighter due to an increase in the number of lower paying jobs. This leads to more demand for retailers who focus on discount items.
I have been impressed with the way Ross Stores, Inc. (NASDAQ:ROST) has been trading and expect the stock to hold up well — even if the broader market comes under pressure.
Ross Stores, Inc. (NASDAQ:ROST) Covered Call Strategy
For our covered call trade today, we’re going to buy Ross Stores, Inc. (NASDAQ:ROST) at the current price near $65.75. You’ll want to buy this stock in 100-share lots so that we can sell calls against the position.
Next, we want to sell the August $65 calls, which are currently trading near $2.60. Remember, we sell one call contract for every 100 shares of stock. The net cost for this position should be $63.15 (the $65.75 stock price less the $2.60 we receive for selling the calls).
Once we sell the August $65 calls, we now have an obligation to sell the stock at $65 when the calls expire, provided the stock is still trading above $65. This means that we would realize a gain of $1.85 from our net cost of $63.15.
The $1.85 gain represents a 2.93% profit over a 45-day period. This is definitely an attractive return considering the fact that if you made a similar trade every 45 days for a year, you would realize a 24% annual gain.
As we head into the second half of 2013, the stock market is looking more vulnerable to a decline. It is important that you develop a strategy to protect your capital from falling stock prices. Using a covered call approach can be a great way to keep your capital growing while protecting yourself from some of the market’s volatility.
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This article was originally written by Zachary Scheidt and posted on ProfitableTrading.
