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OPTIONS TRADING


Covered Call Opportunity In Freeport-McMoran

11/13/08 09:42:48 AM
by Donald W. Pendergast, Jr.

Covered call strategies aren't glamorous, but if you're patient and choose your strikes wisely, a low-risk methodology can be within reach of the average trader.

Security:   FCX
Position:   Buy

Freeport-McMoran Copper and Gold (FCX) has been in a major downtrend since it hit $127.24 in June 2008, shedding nearly 79% of its peak value since then. The stock is currently sitting at a 5-1/2 year low, and all of the recession worries that are hanging over the mining industry make the situation even more depressing. At first glance, it would seem that this stock has nothing going for it, but a closer look reveals that there are a number of ways that an industrious trader whose long-term bullish on FCX can potentially squeeze something from this mining giant's common shares. Follow along as we take an indirect route to (hopefully) profiting on FCX, even if the stock still has some more downside.

FIGURE 1: FCX, MONTHLY. Seeking a bottom, price approaches long-term support.
Graphic provided by: MetaStock.
Graphic provided by: Three indicators from Profit Trader for MetaStock.
 
The monthly chart shows just how bad FCX's plunge has been, but the stochastic and detrend both agree that a low is in sight, with timing unknown (Figure 1). In addition, there is long-term support near $15–16.

Now, a thoughtful trader/investor would look at FCX's dividend yield, currently paying 7.3%, its forward price/earnings ratio of 6.86, and then ask himself if it's possible that FCX is oversold and due for a bounce. But maybe that wouldn't be incentive enough to begin accumulating shares. What if there was another way to profit from FCX shares that included substantial downside protection?


FIGURE 2: FCX, WEEKLY. Signs of a weekly bottom begin to manifest.
Graphic provided by: MetaStock.
Graphic provided by: Three indicators from Profit Trader for MetaStock.
 
The weekly chart's stochastic/detrend combo also confirms that a low may be due, so we start looking at call options on FCX (Figure 2). We learn that we can sell a deep-in-the-money long-term call option against every 100 shares of FCX, a covered call position that will remain profitable even if FCX falls another 32%.

Our trader buys 100 shares of FCX today, paying $22.50 per share, for a total of $2,250. He then works a bid on an FCX January 2010 $15 call option, selling one for $10.50, or $1,050. His net cash outlay is only $1,200 for the position, which is guaranteed to be profitable as long as FCX closes above $15 by the third Friday of January 2010.

How profitable? Well, if FCX is at, say, $18 at option expiration, the shares will be called away at $15, a loss of $750 on the shares, but the $1,050 in premium collected means that the net gain would be $300 for a net cash outlay of $1,200 over a 14-month period. That's a pretty good rate of return in anybody's book. In addition, the trader would also collect approximately $200 in dividends from his long FCX position, bringing the total gain to $500.

Now, of course, there are potential drawbacks to using a deep in-the-money covered call strategy. Here are a couple to consider:

1.) The stock goes far below the strike price and never recovers. For example, if FCX tanked and closed at $8.50 at option expiration, the trader would lose $350 on the entire position. He would still own the shares and could even sell another call option against it if so desired. If the stock were delisted, going to zero, the loss would be $1,200.

2.) The stock rallies hard, causing deep regret over all the missed profit potential of a stock-only position. For example, let's say FCX rallies hard, going from $22.50 to $65 at options expiration. Someone who bought at $22.50 and sold at $65 would make $4,250 for every 100 shares, while the deep in-the-money covered call holder would still be limited to a maximum of $300 in profit plus $200 in dividends.

Although not without risk, the deep in-the-money covered call strategy can be a useful and profitable tool in the hands of thoughtful traders. It's best used as part of a conservative bottom-fishing strategy after major market selloffs.



Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title: Writer, market consultant
Company: Linear Trading Systems LLC
Jacksonville, FL 32217
Phone # for sales: 904-239-9564
E-mail address: lineartradingsys@gmail.com

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