A good time to write a bull put spread is when the long-term outlook is still bullish and the stock has experienced a strong correction. The spread limits your downside risk and provides you with the opportunity to lock in a decent rate of return over a fixed period of time. You also have the chance to get into the stock at a lower price (via the put you sold) and the long put strictly limits your downside risk. Kinder Morgan Energy Partners L.P. (NYSE:KMP), which is the largest independent operator of petroleum-based product pipelines in the United States, meets the above requirements. Kinder Morgan Energy Partners owns and operates over 28,000 miles of pipeline and roughly 180 terminals. It has an excellent history of increasing its distributions and a healthy five-year dividend growth rate of 6.8%.
Benefits of a bull put spread
- It limits your losses if the stock suddenly plunges. Your loss is limited to the total differences between the strike prices of your short put (the put you sold) and long put (the put you purchased).
- The ability to profit even if the stock barely budges in price.
- The risk is significantly lower than writing a naked put as your maximum downside is limited by the put option you purchased.
- The capital requirements are significantly less. With a cash secured put you would need to have enough cash in your account to back the sale of the put. If you sold a put with a strike at $65, you would need to have $6500 in the account. With the bull put spread, your capital requirement is limited to the spread between the two strike prices.
- In the event the stock declines, an investor can buy to close the short put position and continue to lock in gains from the long put as the price of the underlying stock drops.
Reasons to consider Kinder Morgan Energy Partners:
- It just concluded a 25-year natural gas transportation deal in connection with plans to build a pipeline in Mexico.
Under the terms of the deal, El Paso will initially provide about 200 million cubic feet per day of transportation capacity through a new, 60-mile pipeline that would extend from existing pipelines near Tucson, Ariz. and connect with a pipeline to be built in Mexico.
The pipeline's construction remains subject to federal regulatory approvals. El Paso plans to file applications for the needed permits early next year, Kinder Morgan Energy said.
If approved, construction on the pipeline is set to begin in the first quarter of 2014, with the pipeline expected to go into service in September 2014.
- The company's portfolio has expanded with the addition of Tennessee Gas Pipeline and a portion of El Paso Natural Gas. These assets were acquired from its parent company Kinder Morgan Inc (NYSE:KMI).
- It is the largest carbon dioxide transporter in the country.
- It sports a great yield of 6.4%
- It increased its quarterly cash distribution in the 3rd quarter to $1.26 per unit. This represents a 9% increase over its third quarter 2011 cash distribution of $1.14 per unit and it is also higher than its payment of $1.23 per unit in the 2nd quarter of 2012.
- A strong five-year dividend growth rate of 6.8%
- A good interest coverage ratio of 4.20.
- Management has planned the extension of the Trans Mountain pipeline. The company expects to file regulatory applications towards the second half of 2013 and to be commissioned in 2017. This project would increase the capacity to 750,000 bpd from the current 300,000 bpd.
- Consecutive dividend increases for 15 years.
- A total rate return for the last three years of 63%
- A very strong quarterly earnings growth rate of 76%.
- Management expects to declare a cash distribution of $4.98 per unit for 2012. This would represent an increase of 8% over the 2011 payment of $4.61 per unit
- It has increased its capital expenditure budget from $1.9 billion to $2 billion in 2012.
- Zacks has a projected EPS growth rate for the next 12 months of 29% and an estimated 3-5 year EPS growth rate of 21.5%.
Charts and data of value
When a stock is trading above the EPS and EPS consensus estimate line, it is a bullish phase, and the outlook is for higher prices. The stock is trading above the EPS consensus line and so the current correction could prove to be a long term buying opportunity.
$100K invested 10 years ago would have grown to $228K. We simply multiplied the result with 100. The starting value in the above table was $1k.
How does Kinder Morgan Energy Partners hold up against the competition?
The company will be compared against key competitors using key metrics such as P/E, quarterly revenue growth, operating margins, PEG, etc. This will give you further insight into the company, and it could also help you determine if it is the right play for you. It has a very strong quarterly earnings growth rate of 76% and its gross margins of 0.48 are well above the industry average of 0.28.
The stock is in still correcting, and the short term trend is down. It has a pretty decent level of support in the $74.00-$75.00 ranges. However, the support at $70.00 is a much stronger and should serve as a floor against lower prices. Consider waiting for the stock to trade down to the $74.00 ranges before putting this strategy into play. If it tests $74.00, but can close at or above this level by the end of the week, it will have completed a double bottom formation. Double bottom formations are generally bullish formations as they usually lead to higher prices. A weekly close below $70.00 will be a bearish development as it will signal that the stock is ready to test its two-year lows, which fall in 63.50-64.00 ranges. If it closes below $70.00 on a weekly basis, close the spread out and wait for a test of the $63.50-$64.00 ranges before writing a new spread.
The March 2013, 72.50 puts are trading in the $2.14-$2.24 ranges. If the stock pulls back to the stated ranges, the options should trade in the 3.00-$3.15 ranges. We will assume that the puts can be sold for $3.05 or higher.
The March 2013, 70.00 puts are trading in the $1.52-$1.60 ranges. If the stock pulls back to the stated ranges the options should trade in the $2.00-$2.15 ranges. We will assume that the options can be purchased at $2.15 or better.
- After the sale and purchase of the respective puts you will have a net credit of $90.00.
- Your maximum risk is $160 (the spread of $250 is subtracted from the credit of $90).
- Your maximum profit is $90 per spread for a possible return of 56%
- Your breakeven point is $71.60
Risks associated with this strategy
The main risk is that you over leverage yourself because the capital requirements are so small. There is always the chance that the shares could be assigned to your account if the stock is trading below the strike price of the option you sold. If the shares are put to your account, you could always turn around and sell them, provided you had the funds in place to cover the initial purchase.
The net credit you get from the trade is usually much smaller than the maximum amount of money you could lose from the trade. Consider rolling the short option or closing the spread out before your position hits the maximum loss point. Professionals generally take this route when the short option is at or slightly in the money. To roll the short put, you would simply purchase the original put you sold and sell a new out of the money put. If you close the spread out, you can always write a new one.
The strategy we have outlined is a great way to establish a position in Kinder Morgan Energy Partners without taking on too much risk. Your risk is defined right at the beginning and you have the opportunity to lock in a decent rate of return over a relatively short period of time. The Bull put spread limits your total risk to $160.00.
Do not abuse this strategy as there is always a chance that the shares could be assigned to your account. The hedge you have in place via the long put will not prevent the shares from being put into your account.
Options tables from yahoofinance.com. Profit loss table sourced from poweropt.com. P/E, EPS charts and some of the historical data used in this article were obtained from Zacks.com.
It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware.