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"It is not enough to have a good mind; the main thing is to use it well."

Rene Descartes

The covered call strategy is a great way to open a second stream of income and minimize the impact of volatile gyrations on one's portfolio.

What are covered calls?

An investor basically writes a call option (sells calls) that is backed by with the equivalent number of shares, hence the name covered call. If the stock is purchased at the same time a call contract is sold it's often referred to as a "buy write". On the other hand, if the shares are already from a previous purchase, it is referred to as "overwrite." This is the most basic and widely used strategy, which combines the litheness of options with stock ownership.

When you write a covered call income is generated in the form of the premium paid by the option buyer. If the stock trades above the strike price, then the owner will have to sell the shares at that price, if not the owner of the stock gets to keep the premium. The risk of stock ownership is not eliminated. If the stock drops significantly, then the net position will likely lose money, however, using this strategy would reduce the loss factor by the amount in premiums the owner of the shares received for each call he sold. The main risk of a covered call strategy is that the stock might decline significantly in value; in other words, the same risk any share holder bears but with the added benefit of receiving a premium for the calls you sold.

Let us look at an example

Let's say you own 300 shares in stock X which is currently trading at 40, and you think that there is little chance that the stock is going to hit 45 in the next six months. You can then sell calls with a strike of 45; the premium you receive is yours to keep. If in the next six months it does not trade above 45, then you hold onto the shares as well as the premium.

Benefits of employing this strategy

Income generation

Each contract trades at a premium (the higher the beta the higher the premium), and the buyer of the contract pays you that premium for the right to purchase 100 shares of the stock at the strike price. The premium is deposited immediately into your brokerage account.

Downside protection and reduction in Portfolio volatility

If the stock drops in value, the premium collected at least some type of return, and it can offset all or part of the loss depending on how severely the stock has pulled back. For example; if you sold a covered call against a stock when it was trading $20 for a premium of $2.50, then as long as the stock does not drop below $17.50 you are okay. In essence, you have reduced your entry price to $17.50. If this strategy is actively employed, then you could in general significantly reduce the volatility your portfolio is subjected to.

Predetermined rate of Return

This strategy gives you a decent idea of your rate of return on your investment will be. Regardless of what takes place you still get to keep the premium. If your shares are called away from you at the strike price, it is easy to figure your profit; this is the difference from what you paid for the stock and the strike price you sold the option, plus the premium you collected. So let's take the above example. If SDRL trades above 45, your shares are called, and you are out at 45. So your profit is 7 plus the 2.50 which you received in premium for a total gain of 25%.

If the stock starts to drop in price, you lose money on paper (much like any other share holder) when price of the stock falls in excess of the premium you received.

Converts a common stock into a dividend paying stock

The moment you sell the call option, the stock you own, in essence, has turned into a dividend paying-stock; if it already pays a dividend you have turbo charged your gains.

Repeat the process all over again

If your shares have not been called away from you, you can repeat the whole process again with the same shares of stock you own. Utilized properly this strategy can produce an income stream that can surpass the dividend paid out by that specific stock. If the stock does not pay out a dividend, you have just converted into one that does. If the stock is called, there is nothing to prevent you from buying another good stock and repeating the whole process again.

Buy back the call

If you sold the call for a premium of 2.50 and the call is now trading at 1.00, you could buy the call back, and you still get to keep the difference, which in this case amounts to $1.50. You could take things one step further and start the whole process again by selling calls that are fetching higher premiums. For example, you sold calls on stock X when it was trading at 37 with a strike at 40 for a premium of $2.50. The stock is now trading at 34, so you buy the call back and sell new calls with a strike at 37.50.

Atlas Pipeline Partners is our covered call play of choice for the following reasons:

  • A decent yield of 6.10%, more than double that of the current official inflation rate.
  • It has a strong five-year dividend average of 18%
  • It has a strong quarterly revenue growth of 32%
  • A very good long-term debt to equity ratio of 0.41
  • Sales have jumped from $900 million in 2009 to 1.2 billion in 2011.
  • A 5 year sales growth rate of 18.04%
  • A good total debt to equity ratio of 0.41
  • Adjusted EBITDA for the 4th quarter came in at $49 million, an increase of 15% Y-O-Y (year over year) increase.
  • A very sturdy three-year dividend growth rate of 150%
  • A 3 year total return of almost 800%
  • Net income has increased from $60 million in 2009 to $289 million in 2011.
  • A fine interest coverage ratio of 10.3
  • It has a decent free cash flow yield of 7.43%
  • The current $600 million organic growth program is running ahead of schedule.
  • Distributable cash flow surged to $36.0 million in the 4th quarter; this represents an increase of 62% Y-O-Y.
  • Adjusted EBITDA was $181.00 million for the full 2011 year compared to 2010 when the adjusted EBITA came in at $175 million.
  • Distributed cash flow for 2011 was 50% higher than distributable cash in 2010.
  • Atlas Pipeline Partners increased the distribution from 54 cents to 55 cents per unit, a 49% increase Y-O-Y.
  • In the 4th quarter volume of processed gas moved up to 601 MMCFD, an increase of 23% Y-O-Y.
  • 100K invested in APL for 10 years would have grown to $245. 9K

Now for the covered call strategy

Atlas Pipeline Partners faces quite a bit of resistance in the 38-40 ranges and so the following strategy could be implemented. Sell the August 40 calls; they are currently trading in the $0.60-$.70 ranges. Let's assume we sell them at $.65 cents.

Once you sell the calls $0.65 per share is deposited in your account. Each contract covers 100 shares so you need to have at least 100 shares to put this strategy to use. If the stock trades past 40, then your shares will be called, and you will be paid 40 per share. Your total gain will be roughly $3.70 plus the $0.65 you were paid per call for a gain of 11.19% based on today's price of $36.3; this is a pretty good rate of return for six months. Note this does not include any dividend payments you might receive while this strategy is in play, which will only serve to enhance your gains. If the stock does not trade above 40, then you get to keep the premium of $0.65. If your shares are called you still walk away with a nice gain and there is nothing to stop you from implementing the whole process again.

The downside risk is the same risk you would assume if you simply owned the stock but with a small cushion in that, your entry price is technically lowered by the amount of the premium. So let's say you bought the stock at 30, your breakeven point would not drop down to $29.35.

Company : Atlas Pipeline Partners (NYSE:APL)

Levered Free Cash Flow = -118.20M

Basic Key ratios

  1. Percentage Held by Insiders = 0.37
  2. Market Cap ($mil) = 1984

Growth

  1. Net Income ($mil) 12/2011 = 289
  2. Net Income ($mil) 12/2010 = 276
  3. Net Income ($mil) 12/2009 = 60
  1. EBITDA ($mil) 12/2011 = 409
  2. EBITDA ($mil) 12/2010 = 128
  3. EBITDA ($mil) 12/2009 = 171
  1. Cash Flow ($/share) 12/2011 = 3.01
  2. Cash Flow ($/share) 12/2010 = 0.87
  3. Cash Flow ($/share) 12/2009 = 1.79
  1. Sales ($mil) 12/2011 = 1303
  2. Sales ($mil) 12/2010 = 936
  3. Sales ($mil) 12/2009 = 904
  1. Anl EPS before NRI 12/2007 = 1.76
  2. Anl EPS before NRI 12/2008 = 2.41
  3. Anl EPS before NRI 12/2009 = -0.13
  4. Anl EPS before NRI 12/2010 = -0.65
  5. Anl EPS before NRI 12/2011 = 1.3

Dividend history

  1. Div Yield = 6.1%
  2. Div Yield 5 Yr Average 0909/2011 = 9.48%
  3. 5 year dividend growth rate= 7.26%
  4. Annual Dividend 12/2011 = 1.78
  5. Annual Dividend 12/2010 = 0.35
  6. Forward Yield = 5.95

Dividend sustainability

  1. Payout Ratio 09/2011 = 0.77
  2. Payout Ratio 5 Yr Average 09 09/2011 = 1.79
  3. Change in Payout Ratio = -1.02

Performance

  1. Percentage Change Price 52 Wks Relative to S&P 500 = 23.43
  2. Standard Dev Target Price Estimate = 2.12
  3. Average EPS Surprise Last 4 Qtr = 168.66
  4. EPS % Change F2/F1 = 83.05
  5. EPS Growth Q (1)/Q(-3) = 10-100.00
  6. 5 Yr Historical EPS Growth 09/2011 = 5.98
  1. ROE 5 Yr Average 0909/2011 = 6.98
  2. Return on Investment 09/2011 = 9.37
  3. Return on Investment 06/2011 = 8.31
  4. Debt/Tot Cap 5 Yr Average 09/2011 = 49.19
  1. Current Ratio 09/2011 = 0.77
  2. Current Ratio 5 Yr Average = 0.73
  3. Quick Ratio = 0.77
  4. Interest Coverage =10.3

Valuation

  1. Book Value Qtr ($/share) 09/2011 = 23.06
  2. Book Value Qtr ($/share) 06/2011 = 23.71
  3. Price/ Book = 1.61
  4. Price/ Cash Flow = 12.28
  5. Price/ Sales = 1.52
  6. Enterprise value/EBITDA 12 Mo = 6.13
  7. Q1 Std Dev/ Consensus = 0.26
  8. R-squared EPS Growth 09/2011 = 0.01

Notes

It would fall under the category of "great". It has a beta of 1.1 and a good yield of 6.1%; selling covered calls could truly boost ones returns.

CBL & Associates Properties, I (NYSE:CBL)

Industry: REITs

Levered Free Cash Flow : 356.15M

Net income for the past three years

Net Income 2009 = $-15 million

Net Income 2010 = $62 million

Net Income 2011 = $134 million

EBITDA 12/2011 = $713 million

EBITDA 12/2010 = $712 million

EBITDA 12/2009 = $597 million

Net income Reported Quarterly = $118 million

Total cash flow from operating activities

2009 = $431.64 million

2010 = $429.8 million

2011 = $441.84 million

Cash Flow 12/2011 = 2.51 $/share

Cash Flow 12/2010 = 2.73 $/share

Cash Flow 12/2009 = 2.13 $/share

Annual EPS before NRI 12/2011 = 2.05

Annual EPS before NRI 12/2010 = 1.87

Annual EPS before NRI 12/2009 = 2.52

Annual EPS before NRI 12/2008 = 3.22

Annual EPS before NRI 12/2007 = 3.1

ROE = 10.46%

Return on Assets = 2.13%

Quarterly Earnings Growth = 217.4%

Quarterly Revenue Growth = -5.5%

Key Ratios

Price to Sales = 2.59

Price to Book = 1.89

Price to Tangible Book = 2.7

Price to Cash Flow = 7.46

Price to Free Cash Flow = 10.3

Current Ratio 09/2011 = 0.54

Current Ratio 5 Year Average = 0.55

Quick Ratio = 0.54

Cash Ratio = 0.19

Interest Coverage 09/2011 = 2.79

Payout Ratio 09/2011 = 0.38

Payout Ratio 06/2011 = 0.39

Payout Ratio 5 Year Average 09/2011 = 0.44

Payout Ratio 5 Year Average 06/2011 = 0.45

Change in Payout Ratio = -0.06

Dividend yield 5 year average = 8.8%

Dividend growth rate 3 year Average = -8.46%

Dividend growth rate 5 year average = -5.36%

Consecutive dividend increases = 1 years

Paying dividends since = 1993

Total return last 3 years = 900%

Total return last 5 years = -47.54%

Notes

It would fall under the category of "good"

Fibria Celulose SA (NYSE:FBR)

Industry : Paper & Forest Products

Levered Free Cash Flow: -605.01M

Net income for the past three years

Net Income 2009 = $844 million

Net Income 2010 = $344 million

Net Income 2011 = $-521 million

EBITDA 12/2011 = $236 million

EBITDA 12/2010 = $1358 million

EBITDA 12/2009 = $1928 million

Net income Reported Quarterly = $-25 million

Total cash flow from operating activities

2009 = $453.07 million

2010 = $1.03 billion

2011 = $722.8 million

Cash Flow 12/2011 = 1.04 $/share

Cash Flow 12/2010 = 2.79 $/share

Cash Flow 12/2009 = 2.4 $/share

Annual EPS before NRI 12/2011 = -1.38

Annual EPS before NRI 12/2010 = 0.64

Annual EPS before NRI 12/2009 = 0.6

Annual EPS before NRI 12/2008 = -2.21

Annual EPS before NRI 12/2007 = 6.57

ROE = -5.48%

Return on Assets = -2.95%

Quarterly Revenue Growth = -10.5%

Key Ratios

Price to Sales = 1.06

Price to Book = 0.44

Price to Tangible Book = 0.74

Price to Cash Flow = 7.86

Price to Free Cash Flow = -3.9

Current Ratio =2.7

Current Ratio 09/2011 = 2.73

Current Ratio 5 Year Average = 1.63

Quick Ratio = 2.12

Cash Ratio = 1.63

Interest Coverage 03/2012 = N/A

Notes

It would be fall under the category of "average"

Fortress Investment Group LLC (NYSE:FIG)

Industry : Wealth Management

Levered Free Cash Flow : 598.91M

Net income for the past three years

Net Income 2009 = $-909 million

Net Income 2010 = $-782 million

Net Income 2011 = $-1117 million

EBITDA 12/2011 = $-1028 million

EBITDA 12/2010 = $-687 million

EBITDA 12/2009 = $-870 million

Net income Reported Quarterly = $-25 million

Total cash flow from operating activities

2009 = $117.08 million

2010 = $310.16 million

2011 = $168.25 million

Cash Flow 12/2011 = 0.26 $/share

Cash Flow 12/2010 = -0.57 $/share

Cash Flow 12/2009 = 0.14 $/share

Annual EPS before NRI 12/2011 = 0.46

Annual EPS before NRI 12/2010 = 0.72

Annual EPS before NRI 12/2009 = 0.29

Annual EPS before NRI 12/2008 = -0.36

ROE = 9.69%

Return on Assets = 4.68%

Quarterly Revenue Growth = -40.1%

Key Ratios

Price to Sales = 2.14

Price to Book = 1.73

Price to Tangible Book = 3.78

Price to Cash Flow = 14.17

Price to Free Cash Flow = -33.1

Current Ratio 09/2011 = 0.73

Current Ratio 5 Year Average = 0.49

Quick Ratio = 0.73

Cash Ratio = 0.39

Total return last 3 years = 153.59%

Total return last 5 years = -82.1%

Notes

We would rate this below average and walk away from this play. 100K invested for 10 years shrunk to 15K.

Brandywine Realty Trust (NYSE: (NYSE:BDN)

Industry: REITs

Levered Free Cash Flow: 77.49M

Net income for the past three years

Net Income 2009 = $8 million

Net Income 2010 = $-17 million

Net Income 2011 = $-4 million

EBITDA 12/2011 = $348 million

EBITDA 12/2010 = $323 million

EBITDA 12/2009 = $364 million

Net income Reported Quarterly = $1175 million

Total cash flow from operating activities

2009 = $220.41 million

2010 = $185.13 million

2011 = $179.02 million

Cash Flow 12/2011 = 1.58 $/share

Cash Flow 12/2010 = 1.41 $/share

Cash Flow 12/2009 = 1.74 $/share

Annual EPS before NRI 12/2011 = 1.39

Annual EPS before NRI 12/2010 = 1.34

Annual EPS before NRI 12/2009 = 1.87

Annual EPS before NRI 12/2008 = 2.49

Annual EPS before NRI 12/2007 = 2.55

ROE = -0.48%

Return on Assets = -0.2%

Quarterly Revenue Growth = 0.6%

Key Ratios

Price to Sales = 2.73

Price to Book = 0.81

Price to Tangible Book = 0.9

Price to Cash Flow = 7.09

Price to Free Cash Flow = 9.2

Current Ratio 09/2011 = 0.24

Current Ratio 5 Year Average = 0.35

Quick Ratio = 0.24

Cash Ratio = 0.03

Interest Coverage 09/2011 = 0.24

Payout Ratio 5 Year Average 09/2011 = 0.51

Payout Ratio 5 Year Average 06/2011 = 0.52

Dividend yield 5 year average = 17.7%

Dividend growth rate 3 year Average = -12.96%

Dividend growth rate 5 year average = -9.14%

Consecutive dividend increases = 0 years

Paying dividends since = 1996

Total return last 3 years = 413.89%

Total return last 5 years = -52.63%

Notes

It would fall in the range of Average-good.

Conclusion

The markets are extremely overbought and the prudent path to take would be to wait for a decent pullback before committing large sums of money to this market. In the meantime, long-term investors can use the following two options to open up additional streams of income can consider the following two options; sell covered calls or if you are bullish on the stock sell naked puts. Both these strategies could open up additional streams of income.

EPS charts sourced from zacks.com. Free cash flow yield, income from cont operations, and revenue growth sourced from Ycharts.com. A significant portion of the historic data was obtained from zacks.com. Option table sourced from yahoofinance.com.Earning's estimates and growth rate charts sourced from dailyfinance.com.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This list of stocks is meant to serve as a starting point. Please do not treat this as a buying list. It is imperative that you do your due diligence and then determine if any of the above plays meet with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware

Source: 5 Covered Calls: Atlas Pipeline Partners Is Best Of Breed