Earn Double-Digit Income on This Luxury Stock Even If It Goes Nowhere

Shares of luxury handbag and accessories maker Coach (NYSE: COH) have been under pressure for the majority of this year, falling more than 40% from the start of the year to their low last month. Much of the weakness has come as a result of intense competition with rival Michael Kors (NYSE: KORS). In the most recently reported quarter, Coach saw total revenues decline by 7% year over year, while Michael Kors generated 43% revenue growth.

Ordinarily, I would avoid a stock that has lost market share to a key rival. But in this case, there are two strong arguments for initiating a bullish income trade in Coach.

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First, it appears investors have already priced in the poor metrics. The stock has lost more than a third of its value this year and is off more than 50% from its all-time highs near $80, made in early 2012.

Today, the company’s fundamentals appear to be stabilizing with analysts expecting earnings of $1.90 per share in fiscal 2015 (ending in June), followed by a 10% increase in fiscal 2016 to $2.09 per share. If Coach finally gets its act together and begins growing earnings again, investor sentiment could make a turn for the better.

The second piece of good news for Coach is that the company is making strong headway in China. During the past quarter, net sales in the country increased 20% and comparable store sales saw a double-digit percentage increase. This indicates growth due to new stores being added in China, as well as strong sales growth in the existing store base.

If Coach continues to show improvement in China and meets analysts’ expectations, the stock should hold up well and even advance. During the last few weeks, we have already seen shares begin to rebound in what appears to be a bottoming process.

COH Stock Chart

The beauty of today’s trade is that we don’t actually need COH to move higher in order to book a profit. The negative action in the stock over recent months has caused option premiums to swell. This allows us to set up a covered call position with plenty of premium, giving us a cushion of profit in case the stock pulls back.

To enter the trade, we will start by purchasing COH in 100-share lots and selling one COH Oct 37 Call for every 100 shares purchased. The stock is trading at $36.79, and we can sell the option for about $1.07. This makes our net cost $35.72. 

The prices will likely be slightly different when you go to enter your position, but I like this trade as long we can enter it for a cost basis of $35.80 or below. This means that COH could drop as much as 2.7% between now and when the options expire and our position would still be breakeven.

Assuming COH trades for $37 or less on Oct. 17, we keep the $1.07 premium, which represents a 2.9% over the $36.79 stock price in 57 days. If we can repeat a similar trade every 57 days, we’d earn an 18.6% return on our capital in 12 months.

The best-case scenario for this position would be for the stock to move higher over the next eight weeks and close above our $37 strike price. If this happens, we will have an obligation to sell our stock at $37, giving us a $0.21 per-share profit on the stock in addition to the $1.07 that we received from selling the call contracts.

This $1.28 total gain represents a 3.6% profit over our net cost of $35.72 per share. Since the trade will likely conclude in 57 days, our per-year rate of return nets out to 22.9%.

Of course, if Coach remains below $37, we will continue to hold our shares after the calls expire. In this case, we can decide whether we want to close out the position by selling our shares or stick with them and potentially sell more call options.

Whether the stock advances to give us a quick 3.6% (22.9% annualized) return, or holds its ground for a bit longer, COH looks like a solid rebound candidate for the second half of 2014.

Note: Selling covered calls is like collecting “rental income” on the stocks you own. If you’re not renting out the stocks in your portfolio, you may be missing out on the easiest income around. See how you can collect $1,200 or more each month, by clicking here.