The Value Line Daily Options Survey

Our Model Covered Call Portfolio

This week, we update our Model Covered Call Portfolio, bearing in mind that the stock market appears to be have entered a new phase, one in which stocks with proven earning growth will likely perform the best. We also introduce a new format to present our covered calls, using our Excel-based portfolio tracking spreadsheet, PortfolioTemplate.Xls. Subscribers can download this template and use it track to track the portfolio’s P/L, ranks, covered call returns, and protection percentages.

Market Overview

The stock market has scored its best three month rally in over 70 years, with the S&P 500 rising over 30% since early March. Opinions are divided on the market’s next major move, with some analysts anticipating a further 10% to 15% rise by year-end, and others expecting a correction of approximately the same magnitude in the coming months. Our own expectation is for a basically sideways market, with investors trading out of some of the previously-distressed stocks that have led the recent rally and back into stocks with proven earnings growth track records. Consequently, we feel that the coming earnings report season (commencing in July) will be a period that favors stocks that are highly ranked by Value Line.

Within the options market, the past the past three months have seen a contraction of implied volatilities and, in general, a dampening of daily price fluctuations (i.e. historical volatility). Since the beginning of March, the VIX (30-day implied volatility of the S&P 500) has declined from 53% to around 30%, while 30-day historical volatility has similarly fallen. Looking at the options that we rank for covered call writing, we also see a contraction in “implieds,” although our model is still finding plenty of relatively overpriced calls that are suitable for covered call writing. (On average, the 3,593 rank 1 covered calls in our service are 45% overpriced, according to our model.)

A Look at our Portfolio

Since early March, our Model Covered Portfolio has gained more than 25%, helped both by the performance of our underlying stocks and by generally contracting implied volatilities. As we approach the June 21st expiration date, we find that we have five calls that will expire on the following stocks, Abbott Labs (ABT), Genco Shipping (GNK), Microsoft (MSFT), Oracle (ORCL), and United Healthcare (UNH). We also have one other call, the Gilead (GILD) August $50 call, which although it doesn’t expire for a couple of months, offers a breakeven that is less 2% below the current stock price. This call should, in our opinion, be rolled a position that offers more protection.

The Abbot Labs June $47.50 covered call priced at $0.00 (bid) and with the stock at $44.15 covered call offered no incentive to stay in the position. (See Figure 1 on page 3.) We have decided to roll this call out to the August expiration and also down to the at-themoney $44 strike price. This is basically neutral-to-slightly bullish position with only a 4% maximum profit, a breakeven that is 4% below the current stock price and an annualized return of 26%. This call is currently ranked 1 for covered call writing in the Value Line Daily Options Survey. (See Figure 2 on page 3.)

The Genco Shipping June $29 covered call with a bid price of $0.15 and the stock at $24.69 also offered only minimal protection. We have decided to buy the June $29 call back at $0.20 and write the more defensive October $24 call at $5.00. This new position offers a breakeven that 20% below the current stock price and a per annum return of 62%. Its maximum profit (if called away at expiration) is 20%.

Narrowing our Search with AutoFilter

The Microsoft June $20 covered call at $2.57 with the stock at $22.65 is in-the-money and offers only limited profit potential. We have rolled this into the October $23 covered call, which is priced at $1.50. This new position offers a per annum yield of 22%, downside protection of 6% and a maximum profit of 9%.

The Oracle June $20 covered call at $0.80 with the stock at $20.74 also offers limited upside potential. We have rolled this into the September $21 call at $1.20. The new position offers a yield of 23% per annum, downside protection of 5% and a maximum profit of 7%.

The United Healthcare June $28 covered call at $0.10 with the stock at $25.73 offers virtually no downside protection. We have rolled this position into the September $27 call at $2.10. This new position offers an 8% breakeven, a 32% per annum yield and a maximum profit of 14%.

Finally, we have decided to buy back the Gilead Sciences August $50 call at $0.70 and write the November $45 call at $3.70 instead. This longer-term, more defensive, covered call position offers a breakeven of 8% below the current stock price, a per annum return of 20% and a maximum profit of 11%.

Using PortfolioTemplate.Xls

Figures 1 on page 3 shows our model covered call portfolio before the indicated changes and Figure 2 shows the portfolio after the changes. We will be posting the updated portfolio in Excel format in our Model Portfolio directory online. For a review of the use of our portfolio template, see Chapter X in our guide, Quickstudy2008, which you will find in our Reports Archive.

Prepared by Lawrence D. Cavanagh
vloptions@valueline.com