Yesterday, I walked you through the most important letter in finance: F.
The letter F starts the term “Five Spot,” slang for a $5 bill.
It also starts the word “Franklins,” slang for $100 bills.
But yesterday’s article covered the F-score, a mathematical calculation that tells you how strong a company’s balance sheet is based on nine calculations.
Today, I want to discuss an interesting way to trade these companies actively.
You see, Dr. Joseph Piotroski, the founder of the F-score, determined that stocks with a perfect F-score tend to outperform the market.
But buying a lot of a specific stock can cost a lot of money, especially if its shares trade at $100 or more.
So, why don’t we take a look at a way to maximize your gains and limit your risk using a very interesting strategy for an exciting trade.
Trade Like a Poor Man to Get Rich
The trade I want to explain today is known as a “Poor Man’s Covered Call.”
As you know, one of the most conservative trading strategies that you can employ is to sell calls on stocks that you own.
Let’s talk about a stock that has a perfect F-score, sits in the TradeSmith Green Zone, and enjoys upward momentum. While it may be just above the threshold of high risk, it has received multiple upgrades on Wall Street, including a recent target of $141 from JPMorgan Chase.
If you own 100 shares of Lennar Corp. (LEN), trading at $101.78 as of this writing, that position is currently worth $10,178.
You can sell a Nov. 19, 2021, call option with a strike price of $110 for $4.72 (based on Thursday’s price). Since each contract is worth 100 shares, you would collect $472 in premium.
If the stock then gets to $110 by that expiration date, the buyer of the call option would have the right — but not the obligation — to purchase your shares at that strike price.
If the stock hits the strike price and the option is executed, you will collect the difference between $110 per share and your current price of $101.78, plus the premium of $4.72. This represents a per-share gain of $12.94, or $1,294 total.
Of course, if the stock never reaches the strike price, you pocket the premium and generate additional income from your existing position.
But what if you could generate that return without having $10,178 of your portfolio invested in shares to “cover” the trade?
That’s the beautiful part of options.
In The Money, Calls Are the Key
As I showed you earlier, owning 100 shares of Lennar Corp. costs $10,178 (again, as of this writing).
But with options, you can purchase an “in the money” call on the stock at a lower price and own the right to buy that stock by the expiration date.
Yesterday, you could purchase the Jan. 21, 2022, call with a $95 strike price for $1,670.
At any point, you can execute this call option and pay $9,500 (on top of the existing premium that you paid) for 100 shares of LEN stock. But that’s not what this trade is focused on.
Instead, you can use the leverage of this $1,670 and then sell calls on this same stock before your existing option’s expiration date.
The beauty of this is that the returns are nearly identical.
Instead of selling the shares you already own, you can execute the purchase of shares from the call option and deliver them to the trader who purchased your call option.
They receive the shares, but you keep the premium that you generated from the sale of the call option. You will also benefit from the gains achieved by the original call option that you purchased.
The following chart shows the different returns on investment if you sold a “poor man’s covered call” on LEN yesterday. The number on the far right represents the total return possible from the trade.
In the example I just described, an investor would purchase the Jan. 21, 2022, call with a $95.00 strike price for $16.70 per contract. This contract would give them the right — but not the obligation — to buy 100 shares of LEN on or before Jan. 21, 2022, since the strike price is “in the money.”
The investor can then sell the Nov. 19, 2021, call with a strike price of $110.00 for $4.80. Selling this contract would give the buyer the right — but not the obligation — to purchase shares of LEN at $110 if it reaches that strike price.
As you can see, if the stock stays at $102.00, investors will generate a profit.
In addition, an investor can generate maximum gains of $859 should the stock reach $110 and the call is executed (and it remains directly at the strike price).
If the contract that you sold is never executed (doesn’t reach the strike price), you’d still have the long call contract that you bought, with the option to execute the original strike price of $95, and you can sell that call option to close that position.
The maximum loss on this poor man’s covered call is $1,190, which would happen if Lennar stock fell to $59.68. The max loss here is represented by the full cost of the net debit spread ($11.90) received from the simultaneous purchase and sale of these call options.
Now, that might seem like a big loss. But keep something in mind.
If you bought 100 shares of Lennar today and the stock fell from $101.78 to $59.68, you would lose a lot more. It would be a total loss on paper of $4,210.
A poor man’s covered call is just one strategy that you can use to employ less risk and capitalize on leverage to generate strong profits.
It also allows you to take positions on strong stocks like the ones I’ve mentioned with a perfect F-score at a reasonable strike price and reduce your downside.
I’ll be back next week to talk about opportunities and risks for the second half of 2021. I’ll also have a few updates on oil companies.