Low-Risk Income Trade Offers Double-Digit Return Potential

Monday was a key test for the broader stock market. The big question was whether equities could continue to trade higher after a Wall Street Journal story indicating that the Federal Reserve is considering strategies for wrapping up their bond buying program, which means less funny money pouring into the economy.

I believe the Fed wanted to know if the market was strong enough to handle this “bad news.” As it turned out, the market handled the news rather well.

Part of what drove the markets higher on Monday was a positive retail sales report. For the month of April, retail sales were up 0.1%, which was a far cry better than the 0.3% month-to-month decline that economists were expecting.

Of particular note was the apparel industry, which staged the biggest increase of all the categories. It seems that U.S. consumers are feeling confident enough in the overall economy to open up their wallets and spruce up their wardrobes for spring.

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Considering the strength in the apparel market, today we’re going to set up a covered call trade for Express Inc. (NYSE: EXPR), a strong retail company that is poised to break out of a healthy basing pattern.

Express: A Great Value With Plenty of Protection

As I scanned through potential setups in the retail space, I couldn’t believe the opportunity I found in Express.

To start with, the stock is trading at a significant discount to its peers. While many apparel stocks are valued at 15 to 20 times earnings, EXPR has a price/earnings (P/E) ratio of just 11.8. Now, a low P/E doesn’t necessarily mean that a stock is a good investment. Many times, stocks are cheap for a reason — usually because there is a problem with the stock or a significant amount of risk. But in the case of EXPR, the lower valuation appears to be based on an investor misconception.

You see, EXPR doesn’t have the same hyper-growth rate that some of its competitors are enjoying. The company is growing earnings, but over the next year, analysts “only” expect a 13% increase.

Express has been very cautious with their merchandising. They are not willing to buy huge levels of inventory that may or may not sell. The bottom line is that Express is being careful with their growth strategy so that if the economy isn’t as strong as many expect, the company won’t be hurt with huge levels of inventory.

As an investor, I’m much more comfortable with a company that is managing their growth carefully rather than taking excessive risk for unsustainable growth.

So at this point, I’m excited about picking up this quality stock at a discount.

Express’ Breakout Potential

From a technical perspective, the stock is trading in a very attractive pattern.

For the past four months, EXPR has been trading in a tight range after gapping higher in January. This pattern typically indicates that institutional investors are accumulating shares carefully, supporting the stock without pushing it higher (above resistance).

EXPR Chart

As long as the company continues to perform well, I expect EXPR to trade near the top of this range until some catalyst sends the stock to another new high. The catalyst may wind up being the quarterly earnings report, which is scheduled to be released on May 30.

For aggressive traders, buying the stock ahead of the breakout could be a tremendous trade, with the stock potentially rallying sharply once it clears overhead resistance. From our perspective as more conservative covered call traders, there is still a tremendous opportunity to generate profits with a trade that provides protection if EXPR trades lower.

EXPR Covered Call Trade Setup

For our trade today, we’re going to buy EXPR in 100-share lots, and sell the June $17.50 calls against the position. Remember, we will sell one call option contract for every 100 shares of stock that we own.

You should be able to pick up shares of EXPR near $18.90 and the calls for about $2 per share. Buying the stock and selling the calls leaves us with a net cost per share of just $16.90.

I’m particularly excited about this net cost because even if our timing is off on EXPR, the stock can pull all the way back to $16.90 and we still won’t realize a loss on the trade.

Assuming EXPR continues to hold above $17.50, we will have an obligation to sell the stock at $17.50 on June 21. Since our net cost is $16.90, we will recognize a return of $0.60 per share on the trade for a 3.55% gain in 38 days. This return represents a 34% annual gain if we continue to set up trades like this throughout the year.

I’ve covered a number of trades that give us 25% to 35% a year, but this one is particularly attractive given the significant amount of protection we have should the stock back off.

Also, if you’re trading a smaller account, this is an easy trade to get started with because we only need an investment of $1,690 or so for 100 shares and one contract.

As always, I would love to hear what you think about this trade. Please send your comments to Editors@ProfitableTrading.com and mention this covered call article.