With the market back in a confirmed uptrend, the hunt for stocks continues. Many are getting extended or need time to set up properly. Here's an option trade on DraftKings stock that can bring in income on a current leader.
The Covered Call Strategy On DraftKings Stock
DraftKings recently joined Leaderboard after exploding upward on earnings. According to the IBD Stock Checkup, DraftKings stock is ranked No. 2 in its industry group. It has a Composite Rating of 80, an EPS Rating of 65 and a Relative Strength Rating of 98.
Income investors can use a strategy known as a covered call to use a position in DraftKings stock to provide income.
A covered call strategy also slightly reduces the risk on a long stock position since it lowers your cost basis by generating premium. The catch is that you limit your upside potential above the covered-call strike.
Let's look at how a covered call trade on DraftKings stock might take shape.
Buying 100 shares of DKNG stock cost around $3,600 this morning.
A Feb. 16 call option on DraftKings at a strike of 39 traded around 2.80. That means it would reduce your cost basis on the stock by generating $280 in premium per contract.
Selling the call option generates an income of 7.8% in just over three months, equaling around 31.1% annualized.
What Can Happen?
If DKNG stock closes above 39 on the expiration date, the shares will be called away at a price of 39. That leaves the trader with a total profit of $580 (a $300 gain on the shares plus the $280 option premium received).
A $580 profit equates to a 16% return, which annualizes out to over a 70% annualized return on risk.
Of course, there are risks. If DraftKings stock drops, it could wipe out any gains, and then some, made from selling the call. Sure, the premium received would help offset the loss a little but you should still have some type of stop loss.
There is also a potential opportunity cost. If DraftKings stock soars higher, you will only participate up to 39. That could prove costly on profits missed should DraftKings go on a big run.
Covered calls can be an effective strategy for generating income, managing downside risk, and reducing the effective purchase price of a stock.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setup is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
