Source: Enterprise Products Partners
Enterprise Products Partners (NYSE:EPD), is one of the highest-quality, sleep well at night, or SWAN, midstream MLP blue chips you can buy. And thanks to a 73% rally in oil prices since the February low of $26 per barrel, Enterprise investors have had a very good year, beating both the S&P 500 and the Alerian MLP index.
This has resulted in the yield falling to 5.4%, which is still generous and much better than the 2.0% the S&P 500 is offering. However, wouldn't it be wonderful if there was a low-risk strategy to increase that yield? Well lucky for you there are not one, but four potentially good ways to use the awesome power of options to do just that.
Read on to find out how various kinds of investors can potentially immensely profit from various options strategies on one of America's best dividend growth stocks.
Selling cash secured puts: a great way to buy at a lower price, and potentially generate fantastic income
Assuming you want to be a long-term investor in Enterprise Products Partners, the most basic strategy you can use is to sell, i.e. write, cash covered puts. This basically means you provide insurance for another investor who already owns at least 100 units of the MLP and is concerned that it might fall in the future.
Why might Enterprise fall given its high quality, and strong long-term growth potential? Well one reason might be that oil prices halt their recent rally and head back down in the short term. This could happen because the oil crash forced oil and gas producers to become far more efficient, resulting in lower drilling costs and improved profitability, even at today's lower oil prices.
Click to enlarge
Source: Exxon Mobil (NYSE:XOM) investor presentation.
With about 3,900 drilled but uncompleted, or DUC wells in America, and the rig count continuing to rise sharply over the past seven weeks, America's shale oil producers may end up stopping the very rise in crude prices they've been hoping for. That's especially true given slowing global economic growth that could result in slower than expected growth in oil demand.
So now that we understand why someone might be willing to buy a put, let's see just how writing these contracts can help you potentially earn as much as a 40.6% yield.
Source: Yahoo Finance
|Put Option||Premium/Share||Implied Purchase Price||Implied Yield-On- Cost||Premium Yield||Annualized Premium Yield|
|Aug 16 $29||$0.80||$28.20||5.7%||2.84%||40.6%|
|Aug 16 $27||$0.20||$26.80||6.0%||0.75%||9.5%|
|Aug 16 $25||$0.35||$24.65||6.5%||1.42%||18.7%|
|Sep 16 $29||$0.90||$28.05||5.7%||3.39%||22.5%|
|Sep 16 $27|| |
|Sep 16 $25||$0.15||$24.85||6.5%||0.60%||3.7%|
|Dec 16 $29||$1.90||$27.10||5.9%||7.01%||17.9%|
|Dec 16 $27||$0.99||$26.01||6.2%||3.81%||9.5%|
|Dec 16 $25||$0.50||$24.50||6.6%||2.04%||5.0%|
|Jan 17 $29||$1.85||$27.15||5.9%||6.81%||14.3%|
|Jan 17 $27.5||$1.35||$26.15||6.2%||5.16%||10.7%|
|Jan 17 $25||$0.70||$24.30||6.6%||2.88%||5.9%|
Let's say that you really want to own Enterprise Products Partners, and think that oil prices are likely to still keep going up, despite the recent weakness, and risks mentioned above.
You could sell a $29 put that expires August 19 and receive $0.80/share in premium. As the put writer, you would now be contractually obligated to buy 100 units of Enterprise at $29, meaning that, including the premium you've gotten up front, you need to set aside $2,820 in cash for the next month.
If Enterprise stays above $29 then the contract expires worthless and you keep the premium, which paid you $80/$2,820 in tied up capital, or 2.84% over the next month. That comes out to an annualized yield of 40.6%.
Of course, the reason that yield is so high is because Enterprise would only need to fall around 2% for you to have to buy those units. However, remember that this is the "worst-case scenario," owning units of Enterprise with an effective cost basis of $29-$0.80 or $28.20. That means a 5.7% yield on cost, which in today's ultra low rate environment is a phenomenal income return.
Don't forget that Enterprise Products Partners has an unbeatable record of raising its distribution every quarter, no matter what oil prices, or the economy, are doing.
Source: Enterprise Products Partners investor presentation.
This means that your long-term total expected return, based on the rule of thumb yield + dividend growth, is 5.7% yield on cost +4.7% projected long-term payout growth, of 10.4% over the next decade. That is far better than the 9.1% CAGR the S&P 500 has delivered since its inception in 1871.
Covered Calls: If you already own Enterprise and want an even higher yield
If you already own at least 100 units of Enterprise and don't expect the price to rise over the next few months, again due to either falling oil prices, and/or the overheated nature of the stock market in general, covered calls are an option strategy to consider.
Source: Yahoo Finance
|Call Option||Premium/Share||Implied Sell Price||Unit Price Increase to Sell||Premium Yield||Annualized Premium Yield|
|Aug 16 $30||$0.45||$30.45||1.9%||1.48%||19.6%|
|Aug 16 $31||$0.14||$30.86||4.6%||0.45%||5.6%|
|Aug 16 $32||$0.10||$32.10||7.9%||0.31%||3.8%|
|Sep 16 $30||$0.65||$30.65||1.9%||2.12%||13.6%|
|Sep 16 $31||$0.30||$31.30||4.6%||0.96%||6.0%|
|Sep 16 $32||$0.14||$32.14||7.9%||0.44%||2.7%|
|Dec 16 $30||$1.10||$31.10||1.9%||3.54%||8.8%|
|Dec 16 $31||$0.90||$31.90||4.6%||2.82%||7.0%|
|Dec 16 $32||$0.41||$32.41||7.9%||1.27%||3.1%|
|Jan 17 $30||$1.50||$31.50||1.9%||4.76%||9.9%|
|Jan 17 $31||$0.75||$31.75||4.6%||2.36%||4.8%|
|Jan 17 $32.5||$0.45||$32.95||9.6%||1.37%||2.8%|
Writing a call option once again makes you an insurance underwriter, except this time you are ensuring that the buyer of the contract can buy your 100 units at $30 + the premium received.
For example, the highest yielding out of the money call is the August $30 contract, which is paying $.45 per share or $45 per contract written. This means an effective premium yield of 1.48% or 19.6% annualized. The best-case scenario would be for Enterprise to remain below $30 through August 19 so you could keep the premium, and your units.
The risk is that Enterprise soars, say due to a strong rally in oil prices, above that level, and you end up selling for $30.45 per unit rather than a potentially higher future price.
To minimize that risk, you can sell a call that's further out of the money, meaning its strike price is further away from Enterprise's current unit price. For instance, the August $32 call is paying $10 per contract, or 3.8% annualized. You get to keep both the premium and your units as long as the price doesn't rise more than 7.89% above the current price, ($29.65 as I'm writing this).
Now I should note that due to the way MLPs are taxed this strategy is only for those who bought Enterprise recently. That's because the distributions that Enterprise Products Partners pays each quarter are treated as return of capital rather than dividends. That means that they aren't taxed but merely reduce your cost basis, potentially all the way to $0. Beyond that point, they are taxed as long-term income. In other words, the taxes you pay on Enterprise's distributions are deferred until you sell.
Which means that if you have owned Enterprise long enough, your cost basis could potentially be low enough to create a heavy long-term capital gain if your units get called away.
Put + Call combo: For those seeking maximum income, already own Enterprise, and want to buy more
Another strategy you can consider, assuming you have the money to buy at least 100 units of Enterprise and also own at least 100, is to write both an out of the money, or OTM, put and an OTM call.
Source: Yahoo Finance
|Put/Call Combo||Total Premium/Share||Implied Purchase Price||Implied Sell Price||Yield on Purchase Price||Price Increase to Sell||Premium Yield||Annualized Premium Yield|
|Aug 16 $29 Put +$30 Call||$1.25||$27.75||$31.25||5.8%||1.9%||4.50%||70.8%|
|Aug 16 $27 Put +$31Call||$0.34||$26.66||$31.34||6.0%||4.6%||1.28%||16.7%|
|Aug 16 $25 Put +$32 Call||$0.45||$24.55||$32.45||6.6%||7.9%||1.83%||24.7%|
|Sep 16 $29 Put +$30 Call||$1.60||$27.4||$31.60||5.9%||1.9%||5.84%||41.2%|
|Sep 16 $27 Put +$31 Call||$0.70||$26.30||$31.70||6.1%||4.6%||2.66%||17.3%|
|Sep 16 $25Put+$32 Call||$0.29||$24.71||$32.29||6.5%||7.9%||1.17%||7.3%|
|Dec 16 $29 Put+$30 Call||$3.00||$26.00||$33.00||6.2%||1.9%||11.54%||30.4%|
|Dec 16 $27 Put+$31 Call||$1.89||$25.11||$32.89||6.4%||4.6%||7.53%||19.3%|
|Dec 16 $25 Put+$32 Call||$0.91||$24.09||$32.91||6.7%||7.9%||3.78%||9.5%|
|Jan 17 $29 Put+$30 Call||$3.35||$25.65||$33.35||6.3%||1.9%||13.06%||28.3%|
|Jan 17 $27.5 Put+$31 Call||$2.10||$24.40||$33.10||6.3%||4.6%||8.27%||17.5%|
|Jan 17 $25 Put+$32 Call||$1.15||$23.85||$33.15||6.8%||7.9%||4.82%||10.0%|
This generates premiums from both written contracts, with the best-case scenario being that Enterprise Products Partners trades within a narrow range, between the two strike prices.
For example, for those willing to take on large risk of units either being put to you or called away, you can sell both a $29 August put, and a $30 August call for a combined premium of $125, or 4.5% over the next month; an annualized yield of 70.8%.
Of course, this specific option combo also has the risk that you may be forced to sell your 100 units at a price of $31.25, or just 5.5% higher than the current price. Which means that if you think that Enterprise is still extremely undervalued, as I do, then you probably wouldn't want to use this strategy. That's especially true given the potential tax implications described above.
Meanwhile, if Enterprise falls to $29 or below then your effective cost basis becomes $29-$1.25 or $27.75, a 5.8% yield on cost, which gives a projected long-term total return of 10.5%.
Bull put spread: The least risky way to generate income while potentially buying Enterprise for less
One final income strategy I'd like to point out is called a bull put spread. This is basically a hedged way of writing a put contract in hopes of either generating income from Enterprise, or buying more at a lower price.
Source: Yahoo Finance
|Bull Put Spread||Premium/Share||Implied Purchase Price||Implied Yield-On-Cost||Premium Yield||Annualized Premium Yield|
|Aug 16 $29/$27||$0.60||$28.40||5.7%||2.11%||28.9%|
|Sep 16 $29/$27||$0.55||$28.45||5.7%||1.93%||12.3%|
|Sep 16 $27/$25||$0.25||$26.75||6.0%||0.93%||5.8%|
|Dec 16 $29/$27||$0.91||$28.09||5.7%||3.24%||8.10%|
|Dec 16 $27/$25||$0.41||$26.59||6.1%||1.85%||4.6%|
|Jan 17 $29/$27.50||$0.50||$28.50||5.6%||1.75%||4.3%|
|Jan 17 $27.5/$25||$0.55||$26.95||6.0%||2.04%||5.0%|
This strategy involves selling a put, while also buying a put, but at a lower strike price. This generates a net premium but one that is smaller than purely writing a put. That's because the put you buy acts as a hedge, i.e. insurance, against a potential catastrophic collapse of Enterprise Products Partners' price.
For example, say you were eager to buy Enterprise and so didn't mind taking on the high short-term risk of getting units assigned to your account. You sold a $29 August put, and also bought the $27 August put. Your net premium would be $60 per contract. That works out to $60/$2,840 (remaining cash you need to set aside to buy the 100 units, including premium received). That's 2.11% over one month or 28.9% on an annualized basis.
By August 19, Enterprise craters perhaps due to a stock market crash or oil price implosion. Suddenly your effective cost basis of $28.40 is resulting in a 29.6% unrealized loss. Which would likely mean terrible regret, since you'd much rather have been able to buy Enterprise at $20 and lock in an 8.1% yield, than settle for 5.8%. Or you would have this regret except that you hedged against just such a scenario.
Source: Yahoo Finance
|Bull Put Spread||Maximum Potential Loss/Share||Implied Purchase Price (EPD@$20)||Yield-On-Implied Purchase Price (EPD@$20)||Effective Unrealized Loss|
|Aug 16 $29/$27||$1.40||$21.40||7.5%||6.5%|
|Sep 16 $29/$27||$1.45||$21.45||7.5%||6.8%|
|Sep 16 $27/$25||$1.75||$21.75||7.4%||8.0%|
|Dec 16 $29/$27||$1.09||$21.09||7.6%||5.2%|
|Dec 16 $27/$25||$1.51||$21.51||7.5%||7.0%|
|Jan 17 $29/$27.5||$1.00||$21.00||7.7%||4.8%|
|Jan 17 $27.5/$25||$1.95||$21.45||7.5%||6.8%|
Because you own that $27 put, you now have two options. First, if you simply hate the recent volatility and the risk of Enterprise continuing to drop keeps you up at night, then you can always exercise your option to sell your 100 units at $27, a loss of $2 - $0.6 per share, or $140 per contract. In other words, you invested $2900 into Enterprise just before it crashed 31%, yet were able to sell your units at a loss of just $140/$2900 or 4.8%.
However, the real reason that this strategy is so potentially useful is the second option you have. Remember you shouldn't have sold a bull put spread unless you believe that Enterprise Products Partners is a great long-term investment. In other words, that unrealized loss shouldn't bother you since you are confident that in five to 10 years your units will be trading at many times the current $20 price (in this scenario).
In that case, rather than exercise the $27 put, you can sell it to someone who is panicked by the recent collapse, wants out, and is willing to pay dearly to do so. In other words, rather than get shaken out of owning Enterprise by short-term volatility, you act as "the smart money," and take advantage of other investors' fear.
That $27 put now has $7 of intrinsic value ($27 strike price -$20 current unit price), PLUS some amount of time value. The closer you are to the expiration date, the less time value the option will have since the chances of Enterprise's price recovering will be less. For the table above, I assumed a time value of $0, meaning you would sell the put on August 19, purely for the intrinsic value.
Now your cost basis becomes $29-(spread premium received + $7 intrinsic value) or $21.4. In other words, thanks to the insurance you purchased in the form of that $27 put, your cost basis in this low probability but extreme scenario, is just 6.5% above the $20 price Enterprise is trading at in this hypothetical scenario. That means a yield on cost of 7.5%, and a highly attractive projected total return over the next 10 years of 12.2%.
Risks to consider
Options are a great way to earn extra income no matter if the market is rising, falling, or trading sideways. They are also great ways to either buy shares of companies you want to own for cheaper than the current market price, or sell shares in companies you don't want to own at a higher price.
BUT as with most things in life, nothing comes without some risks, and the devil is usually in the details. So here are five things you need to keep in mind before trying any of these strategies.
First, while some investors like to use built in leverage of options to generate potentially fantastic, speculative, short-term profits, I highly advise against that. Which is why I only ever describe or recommend conservative option income strategies that use ZERO leverage. This means only writing an Enterprise Products Partners call if you have the 100 units to cover your contractual obligation, or writing a put if you have the cash to buy the units.
While you may be able to technically sell these options on margin, i.e. "naked," this is a highly risky strategy that could result in a margin call should the unit price move against you. Which could mean your broker might sell some of your other positions at the worst possible time unless you can quickly add cash to your account to meet the margin requirement. Since the entire reason for owning Enterprise Products Partners is to generate generous income, and hopefully long-term market beating total returns with minimal risk, you can see why I advise avoiding selling naked Enterprise options like the plague.
Second, while I've already talked about the potential tax implications of covered calls, don't forget that you'll also need to pay taxes on the premiums you get from selling calls or puts. Option premium is taxed as short-term capital gains, meaning your marginal tax rate.
Which brings me to the third risk/detail to keep in mind: costs. While I didn't include commission costs in the above tables or calculations, in fact, you ALWAYS need to factor these into every investment decision. Broker option fees can vary wildly, from just $0.70 per contract with a $1 minimum at Interactive Brokers (NASDAQ:IBKR), to as high as a $12.95 flat fee for up to 10 contracts at Options Xpress (with an additional $1.25 per contract after that). While those figures might not seem high, keep in mind that, depending on what option strategy and specific contract you sell, it might eat up a lot of your premium. For example, the August 2016 $31 call for Enterprise is only paying $14 per contract, so if you are with Options Xpress and only write one contract that would represent a ridiculous 92.5% commission.
And for those wanting to sell both puts and calls, keep in mind that you will be charged commissions for both. Spread writing is better, at least from a fee standpoint, since most brokers will charge only one commission for both legs of the trade.
A fourth detail to keep in mind also has to do with cost. If at all possible, consider spreading out trading fees over several contracts, thus lowering your overall % commission. For example, selling five December 2016 $29 EPD puts will generate $950 in premium, and if you are with Interactive Brokers, only cost $3.50 in fees representing a commission of 0.4%.
Of course, writing those contracts can only be done by someone with $13,550 to cover the net cost (including the premium received up front) of 500 units of Enterprise should the price fall to under $29 by August 19.
Finally, whenever selling options always remember to use a limit order, as some of the options listed in the above tables have limited volumes and wide bid/ask spreads.
Bottom line: Options are a potentially great low risk way to either buy or sell Enterprise at a better price, while potentially generating even better income from the ultimate SWAN MLP
Don't get me wrong, I'm not saying that option writing is for everyone. However, they can offer highly flexible, and relatively low risk ways for certain investors to meet their individual income or portfolio goals. Just remember to not forget about: commissions, taxes, and of course, avoid naked put writing unless you're willing to bear the very high risk that comes with that kind of leverage.
Disclosure: I am/we are long EPD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.