Buy The Dip In Hewlett Packard (HPQ)

by Mike Scanlin

The combination of a lousy macro environment and bad company-specific news can lead to overselling of an otherwise good stock. After all, when the stock market is diving and investors feel like they need to lighten up on their exposure, many will typically sell the thing that just announced some bad news, creating a "buy the dip" opportunity for others.

That is what has happened to HPQ in the last few days. Yes, they missed numbers and gave weak guidance. But it's a solid company and the overall nasty market has exaggerated the dip. It's times like this when a short-term buy-write (covered call) has good odds of doing well, as most of the people who wanted to sell have already sold.

HPQ Stock Price Last 6 Months (Aug 25, 2010, to Feb 24, 2011)

The good news is that if you're going to buy the dip like this you can sell an in-the-money covered call to give yourself additional downside protection and collect time premium.

HPQ's next earnings aren't until May, so the March and April option cycles are not subject to earnings releases. There is an 8 cent dividend that goes ex-dividend on Mar 14, so both March and April option cycles will collect that dividend.

We have 3 ways to buy this dip with a buy-write strategy depending on your risk level.

For the more conservative 1%/month club (12% or more annualized return):

For the semi-aggressive 2%/month club (24% or more annualized return):

For the risk-loving 3%/month club (36% or more annualized return):

In each case the Net Debit it your cost to put on the buy-write investment (cost to purchase the stock minus the premium you receive for selling the call option). It is also your break even point for the trade (if HPQ finishes above your Net Debit on option expiration day then you have a profit).

If you owned HPQ before the recent dip then you probably do not want to sell one of these in the money options, as you would be locking in the loss from the dip. In those cases you may want to wait for the stock to rebound a bit, or sell some near-term (March) out of the money calls so you can get a little income while you wait.

There is another, more aggressive strategy called "legging in" where you buy the stock first and then wait until it has risen a point or two before selling an in the money covered call. Not a bad strategy but definitely has more risk (and potential reward) than just doing a buy-write right out of the gate.

Dip buying is not for everyone. But when you combine it with in the money covered calls on solid companies you reduce the risk and could collect some nice premium.

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.

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