This Trade Could Make You a 10% Return in 4 Months

Income is on the minds of more and more traders.

Some are using dividend stocks to replace bonds and others are using high-yield bond funds, which always seem to fall more than stocks in a sell-off.

In my opinion, the best income strategy involves using options.

Selling puts is one way to generate steady income in the stock market, as I write about in my service, Income Trader. Selling covered calls is another strategy that traders should consider.

[ad#Google Adsense 336×280-IA]Covered call writing involves selling call options on stocks you own.

Each options contract covers 100 shares of stock, so you can sell one covered call for each 100 shares of stock that you own.

I believe covered call writing has less risk than owning a stock outright.

If the stock falls, the income from the covered call offsets at least part of the loss.

If the stock goes up, you get a guaranteed gain and have a chance to reinvest the profits from your winning trade. Call writers also enjoy the same dividend shareholders receive, so covered calls, from a long-term perspective, are income enhancers.

Vale (NYSE: VALE) is a great stock to use a covered call writing strategy. VALE offers exposure to base metals, an inflation hedge. The company is the second largest metals and mining company in the world.

It is the world’s largest producer of iron ore and iron ore pellets, key raw materials for steelmaking, and the world’s second largest producer of nickel, a critical component of stainless steel and batteries.

VALE also produces manganese, ferroalloys, thermal and coking coal, copper, cobalt, platinum group metals, and has diversified into fertilizer nutrients.

In short, VALE is involved in delivering important raw materials for the global industrial and food production industries.

VALE offers strong value in this sector with a price-to-earnings (P/E) ratio of 8.5, about one-third below the sector average of 12.7. It has a higher-than-average dividend yield of 3.1%. This stock is covered by 21 Wall Street analysts who have a median price target of $22.50, about 15% above the current price.

Rather than use a simple buy-and-hold strategy with VALE, I think a covered call writing strategy reduces risk while maintaining a high potential reward. VALE is trading at about $19.51. You can buy 100 shares for $1,951 and sell an out-of-the-money call with a strike price of $21 that expires in June for $0.53 to reduce your out-of-pocket expense by $53.

When the option expires in June, you will face one of two outcomes:

1. If VALE is below $21, you keep 100% of the premium, and you essentially lower your cost basis on the stock to $18.98. ($19.51 – $0.53 premium).

2. If VALE is above $21, the stock will be called away at $21, meaning you will make $1.49 on the stock plus your $0.53 premium for a return of 10.35% in four months. If you repeated this with a similar trade two more times within 12 months, the annual return would be more than 30%.

VALE is a good long-term holding, and if the price drops, you could continue selling calls to lower your cost basis even more. If VALE does move higher, a 10% gain in only four months is a great return for an income investment.

Covered calls are an effective income strategy as VALE shows, and there are a number of stocks with calls that offer attractive returns like this.

Recommended Trade Setup:

— Buy Vale (VALE) at the market price and sell one VALE June 21 Call for every 100 shares purchased
— Do not use a stop-loss
— If VALE is above $21 when the option expires, you will have a 10.35% gain in four months
— If VALE remains below $21, you will still own the stock and be able to sell additional calls

Amber Hestla-Barnhart

Sponsored Link: Amber Hestla-Barnhart is a featured contributor to numerous trading publications including Technical Analysis of Stocks & CommoditiesStocks, Futures and Options, and Shares, a weekly trading magazine published in the United Kingdom. She’s also just released a new special report detailing how to generate instant income thanks to a little-known glitch in the options market. To see this report and learn how it could help you increase your income, click here.

Source: ProfitableTrading