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"Think you can, think you can't; either way, you'll be right."

Henry Ford

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. It is a very safe strategy to use as it does not increase an investors risk and to some degree provides some downside protection.

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.

CBL & Associates Properties is our covered call play of choice:

  • It has decent levered free cash flow of $356 million.
  • Net income has been trending upwards for the past 3 years; it increased from $-15 million in 2009 to $134 million in 2011
  • EBITA has increased from $597 million in 2009 to $713 million in 2011
  • Cash flow per share has increased from $2.13 per share in 2009 to $2.51 in 2011.
  • It has a very impressive quarterly earnings growth rate of 217%
  • A low payout ratio of 38% and good 5 year average payout ratio of 44%
  • It has acceptable interest coverage ratio of 2.8
  • The percentage short of float is a high 13% and this makes it a candidate for a potential short squeeze.
  • A strong free cash flow yield of 16%
  • A good 5 year dividend average of 8.8%
  • A stunning 3 year total return of 900%
  • 100K invested for 10 years would have grown to 186k.

Covered call strategy for CBL & Associates Properties

It faces some resistance in the 19-20 ranges and so the following strategy could be implemented. Sell the September 20 calls; they are currently trading in the $0.80-$1.15 ranges. Let's take the midway point and assume we sold the calls at roughly $1.00.

click to enlarge

Once you sell the calls $1.00 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 20, then your shares will be called, and you will be paid 20 per share. Your total gain will be roughly $1.08 plus the $1.00 premium you were paid per call for a gain of 10.9% based on today's price of $18.92; 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 20, then you get to keep the premium of $1.00. 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.

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". EBITDA, Net income and cash flow per share have generally been trending upwards for the past few years.

Newcastle Investment Corp (NYSE:NCT)

Industry: REITs

Free Cash Flow: $24.9 Million

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $-210 million
  3. Net Income 2010 = $622 million
  4. Net Income 2011 = $259 million
  1. EBITDA 12/2011 = $353 million
  2. EBITDA 12/2010 = $775 million
  3. EBITDA 12/2009 = $-19 million
  4. Net income Reported Quarterly = $21 million
  1. Total cash flow from operating activities
  2. 2009 = $74.17 million
  3. 2010 = $48.89 million
  4. 2011 = $57.04 million
  1. Cash Flow 12/2011 = 0.7 $/share
  2. Cash Flow 12/2010 = 10.91 $/share
  3. Cash Flow 12/2009 = 5.88 $/share
  1. Annual EPS before NRI 12/2011 = 1.44
  2. Annual EPS before NRI 12/2010 = 12.19
  3. Annual EPS before NRI 12/2009 = 6.16
  4. Annual EPS before NRI 12/2008 = -0.11
  5. Annual EPS before NRI 12/2007 = -1.52

Performance

  1. ROE = 226.55%
  2. Return on Assets = 5.42%
  3. Quarterly Earnings Growth = -89.6%
  4. Quarterly Revenue Growth = -70.7%
  1. Price to Sales = 2.36
  2. Price to Book = 5.28
  3. Price to Tangible Book = 5.28
  4. Price to Cash Flow = 9.37
  5. Price to Free Cash Flow = 27.6
  1. Current Ratio 09/2011 = 45.26
  2. Current Ratio 5 Year Average = 75.11
  3. Quick Ratio = 45.26
  4. Cash Ratio = 6.45
  5. Interest Coverage 09/2011 = 1.65
  6. Total return last 3 years = 694.44%
  7. Total return last 5 years = -65.39%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.22
  2. Payout Ratio 06/2011 = 0.11
  3. Payout Ratio 5 Year average 09/2011 = 0.29
  4. Payout Ratio 5 Year average 06/2011 = 0.36
  5. Change in Payout Ratio = -0.08
  1. Dividend yield 5 year average = 11.5%
  2. Paying dividends since = 2002

Notes

It would fall under the category of average-good. The reason we mention average is because net income, cash flow and EBITDA took rather big hits from their 2010 levels.

Donnelley (R.R.) & Sons Co. (NASDAQ:RRD)

Industry: Printing

Levered Free Cash Flow: 793.84M

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $-27 million
  3. Net Income 2010 = $222 million
  4. Net Income 2011 = $-123 million
  1. EBITDA 12/2011 = $556 million
  2. EBITDA 12/2010 = $1085 million
  3. EBITDA 12/2009 = $907 million
  4. Net income Reported Quarterly = $21 million
  1. Total cash flow from operating activities
  2. 2009 = $1.43 billion
  3. 2010 = $752.5 million
  4. 2011 = $946.3 million
  1. Cash Flow 12/2011 = 4.83 $/share
  2. Cash Flow 12/2010 = 4.4 $/share
  3. Cash Flow 12/2009 = 4.44 $/share
  1. Annual EPS before NRI 12/2011 = 1.82
  2. Annual EPS before NRI 12/2010 = 1.76
  3. Annual EPS before NRI 12/2009 = 1.6
  4. Annual EPS before NRI 12/2008 = 2.94
  5. Annual EPS before NRI 12/2007 = 2.94

Performance

  1. ROE = 20.57%
  2. Return on Assets = 4.06%
  3. Quarterly Revenue Growth = 0.5%
  1. Key Ratios
  2. Price to Sales = 0.21
  3. Price to Book = 2.25
  4. Price to Tangible Book = -1.28
  5. Price to Cash Flow = 2.63
  6. Price to Free Cash Flow = 6.6
  1. Current Ratio 09/2011 = 1.4
  2. Current Ratio 5 Year Average = 1.42
  3. Quick Ratio = 1.16
  4. Cash Ratio = 0.27
  5. Interest Coverage =0.10
  6. Total return last 3 years = 124.01%
  7. Total return last 5 years = -51.24%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.57
  2. Payout Ratio 06/2011 = 0.55
  3. Payout Ratio 5 Year Average 09/2011 = 0.49
  4. Payout Ratio 5 Year Average 06/2011 = 0.48
  5. Change in Payout Ratio = 0.08
  1. Dividend yield 5 year average = 7.4%
  2. Paying dividends since = 1911

Notes

It would fall under the average category; net income and EBITDA have taken big hits. It also sports a very weak interest coverage ratio, and quick ratio. Annual EPS before NRI is below 2007 and 2008 levels. Individuals willing to take on risk could do well, but we would wait for the markets to pullback before getting into this play and we would also sell covered calls if long positions were opened.

Seadrill Ltd (NYSE:SDRL)

Industry: Production & Extraction

Levered Free Cash Flow: -1.01B

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $1261 million
  3. Net Income 2010 = $1172 million
  4. Net Income 2011 = $1506 million
  1. EBITDA 12/2011 = $N/A million
  2. EBITDA 12/2010 = $2054 million
  3. Net income Reported Quarterly = $21 million
  1. Cash Flow 12/2011 = 4.22 $/share
  2. Cash Flow 12/2010 = 3.95 $/share
  1. Annual EPS before NRI 12/2011 = 2.9
  2. Annual EPS before NRI 12/2010 = 2.69
  3. Annual EPS before NRI 12/2009 = 2.6

Performance

  1. ROE = 20.29%
  2. Return on Assets = 7.42%
  3. Quarterly Revenue Growth = -6.8%
  1. Key Ratios
  2. Price to Sales = 4.21
  3. Price to Book = 2.79
  4. Price to Tangible Book = 3.43
  5. Price to Cash Flow = 8.92
  6. Price to Free Cash Flow = -7.4
  1. Current Ratio 09/2011 = 0.73
  1. Quick Ratio = 0.73
  2. Cash Ratio = 0.46
  3. Interest Coverage =6.80
  4. Total return last 3 years = 333.71%
  5. Total return last 5 years = 180.76%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 1.07
  2. Payout Ratio 06/2011 = 1.07
  3. Payout Ratio 5 Year Average 09/2011 = 0.68
  4. Change in Payout Ratio = 0.39
  1. Dividend yield 5 year average = 6.8%
  2. Dividend growth rate 3 year Average = 161.54%
  3. Dividend growth rate 5 year average = 0%
  4. Consecutive dividend increases = 2 years

Notes

The outlook continues to improve going forward as it continues to secure long term deals and the daily lease rates it commands for it's for rigs are surging to record levels. As it sports a high beta this is a good stock to sell covered calls. It also has a great yield of 8.50% and a healthy 5 year dividend average of 6.8%. It would fall under the category of "good".

United Microelectronics Corp. (NYSE:UMC)

Industry: Semiconductors

Levered Free Cash Flow: -745.20M

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $52 million
  3. Net Income 2010 = $822 million
  4. Net Income 2011 = $357 million
  1. EBITDA 12/2010 = $1917 million
  2. EBITDA 12/2009 = $1120 million
  3. Net income Reported Quarterly = $21 million
  1. Total cash flow from operating activities
  2. 2008 = $1.38 billion
  3. 2009 = $1.02 billion
  4. 2010 = $1.84 billion
  5. Cash Flow 12/2010 = 0.75 $/share
  6. Cash Flow 12/2009 = 0.46 $/share
  1. Annual EPS before NRI 12/2011 = 0.14
  2. Annual EPS before NRI 12/2010 = 0.33
  3. Annual EPS before NRI 12/2009 = 0.05
  4. Annual EPS before NRI 12/2008 = -0.04
  5. Annual EPS before NRI 12/2007 = 0.16

Performance

  1. ROE = 5.14%
  2. Return on Assets = 4.13%
  3. Quarterly Earnings Growth = -84.7%
  4. Quarterly Revenue Growth = -24.3%
  1. Key Ratios
  2. Price to Sales = 1.89
  3. Price to Book = 0.98
  4. Price to Tangible Book = 1.03
  5. Price to Cash Flow = 3.61
  6. Price to Free Cash Flow = -7.4
  7. Current Ratio 09/2011 = 1.91
  8. Current Ratio 5 Year Average = 2.58
  9. Quick Ratio = 1.58
  10. Cash Ratio = 1.58
  11. Interest Coverage =177
  12. Total return last 3 years = 15.05%

Dividend sustainability and history

Payout Ratio 09/2011 = 1.02

Payout Ratio 06/2011 = 0.65

Payout Ratio 5 Year Average 09/2011 = 0.52

Payout Ratio 5 Year Average 06/2011 = 0.46

Change in Payout Ratio = 0.51

Consecutive dividend increases = 1 years

Paying dividends since = 2008

Notes

Net income dropped by more than 50% from its 2010 levels and Annual EPS before NRI also came in lower. For now we would place it in the "average "category. Risk takers, however, could do well going forward as the stock appears to have bottomed in Oct 2011 and is now trending upwards. We would wait for a pullback before jumping in. Ideal entry points would be in the 20-22 ranges.

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 could open up additional streams of income by selling sell covered calls.

Sources: EPS, EPS surprise, broker recommendations, and price and consensus 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

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: CBL Is Our Play Of Choice