Earlier this year, I took my family to Disney World. About halfway through our day my wife started to experience sharp pains.
She immediately looked it up online through the website WebMD (Nasdaq: WBMD), a go-to source for everything medical-related, to see if she could figure out the reason. But trust me, this only made things worse.
Everything came up, from a ruptured appendix to cancer. And this wasn’t the first time the website had done this. In fact, some type of cancer is almost always in the list of results, and it often causes needless anxiety for users, my wife included.
The reason I’m sharing this story with you is because it supports why we’re selling naked calls on WebMD today. We’re also taking profits in three open positions, but I’ll get to that in a moment.
First, the new trade…
WebMD has been around for a while now, and concerns about the company’s diagnosis abilities have cropped up since the start. But now investors are starting to show increased bearishness for the stock.
Take a look at this chart to see what I mean:
The black line at the top is a “downward sloping resistance level.” It tells me that buyers of the company are running out of steam. During each rise, the stock failed to make new highs.
That resistance level was tested about four times this year, and, as you can see, it held each time. So we’re going to sell naked calls on WebMD today because I expect it to hold again.
WebMD’s diagnosis effectiveness is one mark against the company, but there are a few other factors that tell me investors will continue to be cautious. For one, the stock is ridiculously overvalued. It has a hefty 38 times earnings valuation, more than three times its projected earnings growth rate. That’s an expensive valuation for any company. Just for comparison’s sake, a stock less than one times its growth rate is cheap, at one times its growth it’s fairly valued and anything above that is getting into overpriced territory.
The company is also carrying a substantial debt-to-equity ratio of 1,087% — which is a massive amount. Ideally you want companies at less than 100%, which means their equity is larger than their debt load. Clearly that’s not the case for WebMD.
That’s why I believe shares will continue to drift lower in the coming weeks, which makes today a great time to sell naked calls.
Action to take: Set a Good ‘Til Canceled limit order to sell to open the WBMD January 2016 $45 call option (WBMD160115C00045000) at $1.70. At last glance, it was trading at $1.80. If your order is not filled by my next dispatch, I will update you on the trade.
How the Trade Works
Since each contract covers 100 shares, you will collect $180 per contract sold.
In a cash-secured call transaction, in which you keep enough cash in your account to buy and sell that amount of stock, you will need to deposit $4,500 with your broker. This will give you a yield of 4% ($180 divided by $4,500) in about three months.
If you use margin, you will need to deposit about $900, a fifth of the full amount, with your broker. This will give you an impressive yield of 20% ($180 divided by $900) in about three months.
By selling calls, our risk is that shares rise. That’s why I have picked a stock I believe is poised to fall. If shares are below our $45 strike price by January 15, we will keep the premium we collected and move on to another trade.
We won’t have to worry about our shares being above our strike price on the expiration date, because I will close the position prior to then.
If shares seem like they’re starting to rally, I will close our trade to limit our losses, so pay close attention to your inbox. On the other hand, if the stock moves lower in quick fashion, I will look to lock in the premiums we already collected.
Time to Take Profits
After volatility erupted in late August, markets have calmed down significantly, and they’ve even rallied toward new highs. It’s what helped create the opportunity for selling naked calls on WebMD.
However, until the market sets higher highs and higher lows, stocks will remain volatile for some time — and will likely even enter into a bear market. As you know, that’s the main reason we initiated a naked-call strategy.
Therefore, I want to use the recent surge in stock prices to take some profits off the table in three positions.
By doing this, we’re not only locking in gains; we’re also freeing up some capital to take advantage of another possible dip in the stock market.
Action to take: Buy to close the Western Union (NYSE: WU) November 2015 $18 put option (WU151120P00018000) at the market. At last glance, it was trading at $0.35.
Action to take: Buy to close the AT&T (NYSE: T) November 2015 $34 put option (T151120P00034000) at the market. At last glance, it was trading at $0.90.
Action to take: Buy to close the GlaxoSmithKline (NYSE: GSK) November 2015 $37 put option (GSK151120P00037000) at the market. At last glance, it was trading at $0.15.
With these trades, you are locking in gains (based on a margin account) of roughly 9.7% from Western Union, 6.7% from AT&T and 12.5% from Glaxo in only three months or less. In a cash-secured account, you would see gains of 1.9%, 1.3% and 2.5%, respectively.
That’s all for this week. I’ll be back next week unless I see an opportunity before then.
Editor, Pure Income