Covered Call Opportunities
Declan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It has been a great few months for bulls, especially for those who had bought early in the rally, and for late arrivals who took advantage of the November dip. However, knowing when to take money off the table is never easy, particularly when momentum is working strongly in your favor. One way to take advantage of strong bullish momentum is to sell covered calls on your existing holdings.
What is a covered call?
A covered call is an option transaction where the seller of the call, who also owns shares, creates a contract which offers the buyer, the right to purchase the shares at a fixed price, within a given time frame. The seller earns a premium from the sale. If at the time of expiration of the contract, the share price is higher than the contract price, then the contract is exercised and the shares are sold at the agreed price ('strike price'). If at expiration the share price is less than the strike price, the contract expires worthless and the seller of the call keeps the shares.
The benefit of the covered call is it allows the shareholder to earn money by selling options. The disadvantage, is if the share price heads south quickly, well then it may be necessary to buy back the option contract before selling the shares, compounding the loss. Therefore, the best candidates for covered calls are stocks which are in long standing uptrends, selling an option contract at a strike price above the current price. This earns the seller the premium from the contract sales, plus any capital gain from the sale of the stock at the strike price if the option is exercised. Ideally, you like to keep the premium and the shares so you can repeat the process!
Covered call candidates
A number of stocks have made strong gains since I have featured them, and thus are ideal candidates for this strategy. Tesoro Corporation (NYSE: TSO), Krispy Kreme Doughnuts (NYSE: KKD), and Tenet Healthcare (NYSE: THC) have all achieved gains over 50% since featured.
Tesoro Corporation emerged from a 4-month base after clearing $46. Opinion suggests there may be more upside to follow. Lower costs for oil refining, driven by developments in shale oil and gas, have reversed a rough period for the industry since the start of the recession. In Tesoro's case, the increase in crude oil production from Canadian oil sands has provided a much needed boost to the U.S. refinery sector. While domestic demand for refined products is expected to decline in the long term, demand from Latin America is expected to grow; this will greatly benefit Tesoro Corporation over the coming decade. Latin America consumed 8.5 million barrels/day of refined product in 2011, but should reach 10 million before 2020. At this time, domestic consumption is expected to be unchanged at around 16 million barrels/day, which is below the mid-noughties peak of 18 million barrels/day. Increased global exports could add another 10% by 2020.
Tesoro's P/E of 11.6 is below the Industry average of 15.3; another marker flavoring higher prices. At time of writing, a $50 May 2013 option call traded at $3.40 (when the stock closed at $48.69). To buy the underlying, and sell the call could net a potential 9.7% return over the 3.5 months, assuming the stock didn't drop below the buy price.
Krispy Kreme Doughnuts price doubled since the mid-November swing low. When featured back in September it carried a P/E of 3.3, but this has pushed to 5.7 following the huge price advance. However, the key reason for the low P/E is an income tax expense credit which added $135.9 million to net income. Removing the tax credit from income gives an adjusted P/E of 27.7. This adjusted P/E is still well below direct competitor Dunkin' Brands Group's 81.3, and is comparable to Starbucks' 30.2. So while the price advance is incredible, the stock is not necessarily expensive. Revenue was up 8.5% last quarter, with an impressive 6.8% increase in same store sales. The company continues its aggressive international expansion as it opens its first franchise spot in India, in addition to a partnership plan with Citymax Hotels for 80 more retail spots (to be built over 5 years). There was also a new franchise development for Singapore. Where the risks lie is increased raw material costs, but given deflationary pressures on commodity prices these should be manageable.
Because the stock has advanced so far so fast, it can be hard to pick a good time point to sell a covered call. At time of writing, Krispy Kreme Doughnuts had closed at $13. On that day, the soon to expire February $13 strike call option traded at $0.40, the same strike March call went for $0.63 and the May $13 call at $1.10. However, when profit taking does kick in, Krispy Kreme could take a sharp fall. If you are unwilling to sell, but still want to take money off the table, then writing a call at a lower strike price (below $13) offers an additional $0.10-$0.20 in time premium at May expirations.
The last stock, Tenet Healthcare, has enjoyed a good run since last summer, helped by Obama's re-election. Negative opinion on the stock has focused on high debt management risk, weak operating cash flow and poor profit margins. However, the company was able to secure sub-5% notes in a new record for the company. This will bring improvements to cash flow and debt management as more expensive debt is refinanced. The company's debt has become more attractive because of the benefits the Affordable Care Act will bring to the sector over the long term. Health care spending arising from the Act is expected to grow from $2.8 trillion in 2012 to 4.8 trillion in 2021, a 70% increase. Existing earnings have also enjoyed significant growth. Tenet Healthcare reported net income of $31 million in Q3 (EPS of $0.28), compared to $14 million in the same quarter in 2011. Projections call for an EPS of $0.70 in Q4, compared to a reported $0.32 last year.
As a defensive stock, Tenet Healthcare should be more resilient to a drop in the broader market. The stock is still enjoying the early phase of a new rally after a lengthy period of sideways action. Where before the stock found sellers when it climbed above $25, it should now find buyers. However, the price has doubled in less than a year, and around $40 a share it may be a little hot for its own good. May expiration strike $40 calls were priced at $2.05, with March expiration trading a respectable $1.45. The latter probably is the better offer.
fallond has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!