GM: How you might make a 45% annualized return on poor old General Motors; dividend yield is 6.2%

General Motors (GM) dropped 4.1% Wednesday, but some speculators figure they’ll make an annualized return of between 45% and 57% on GM between now and mid July.

If you buy 100 shares of GM at Wednesday’s closing price of $16.12 and sell one call option contract (100 shares) with a strike price of $17.50 per share for 76 cents a share, you will make an annualized return of 45.32%. This is called a covered call trade, because your sale of a call contract is covered by your purchase of an equal number of shares of the underlying stock, which is GM common.

To accomplish this, the stock has to be trading below its strike price of $17.50 when the option expires in 36 days and at or above the price you paid for the stock. If the stock closes below $17.50, or out of the money, you keep the 76 cents a share you got when you sold a contract for 100 shares, or $76.

Assume that after the GM July 17.50 call expires, you can sell a GM September 17.50 call that also yields 45%. This is unlikely, because the September call option will be priced in July to reflect whatever GM is trading at and how both stock and option traders think GM will trade during the next month or so. A call option with a $17.50 strike price gives the buyer of the call the right to purchase 100 shares per contract at $17.50 even if the stock is trading at a higher price.

At Wednesday’s close, GM August 17.50 calls were trading to yield 36%. A covered call’s return can change quickly. Early Wednesday, for example, I bought GM at $16.57 and sold call contracts for an equal number of shares at 96 cents, or 5.8% of the stock’s price. In other words, by selling call options, I reduced my effective price by 5.8% to $15.61. At the time of the trade, my projected annualized return was almost 58%, well above where the covered call closed Wednesday night.

Why do a covered call trade on GM when it’s stock appears to be in a free fall?

First, the 45% to 57% return is pretty good.

Second, Morningstar.com, an independent stock market research firm says the estimated fair value of GM’s stock is $27. Morningstar says its fair value estimate carries a high degree of uncertainty. In Morningstar lingo, that makes GM, which is trading a little below 60% of fair value a very undervalued, four-star stock. Five stars are the most that Morningstar gives a stock. It means not only that the stock is undervalued and that it may take a long time to recover to its fair value or higher, but also that it is out of favor with investors and riskier than stocks that are fairly valued. Fairly valued stocks are three-star stocks, and very overvalued stocks are one-star stocks.

Third, GM is both a four-star stock and a very good dividend payer, so far. At Wednesday’s close, GM’s $1 projected annual dividend provides a yield of 6.2%, unless GM cuts its dividend, which it could given the lousy new auto market.

When you combine the projected 45% to 57% annualized return on the covered call trade, the probably small chance that the stock will rally some 40% to $27 a share over the next two to five years and the 6.2% dividend, GM looks like it’s worth a small speculative swing for the fences.

Warning: This is a risky and highly speculative trade. Don’t put a high percentage of your trading capital into such a trade. If GM drops to, say, $9 or $13, you’ll be in a deep hole for a long time unless you cut your losses at 10% to 20% of your initial cash outlay.

I made the small trade intending to stick with GM through thick or thin, counting on it to turn around during the next three years and to continue to pay its $1 per share dividend. My plan is to write out of the money covered calls against the stock to generate additional income. When GM is trading for $16.12 and the strike price on the call option is $17.50, the covered call trade is out of the money.

I want the stock to close below $17.50 so the option will expire worthless and I can continue collecting dividends and writing covered calls on the stock. But I don’t want the stock to go much lower, which it very well could.

GM’s daily, weekly and point and figure charts are here. They’re all bearish, and the point and figure price objective is $9. A price objective is not a prediction, it’s a trend projection which could change overnight.

This is the same strategy I’m using in trading Bank of America (BAC) and several other stocks. I blogged on my BAC trade here.

Full disclosure: I own GM and am short GM July 17.50 calls, which makes me long a GM covered call.

For educational purposes only. Before you trade covered calls, read some books on options trading and search the Web for more information. There are no guarantees that trades describe on this blog will work out as planned.

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