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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 investor's 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 offers 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 OK. 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 SeaDrill (NYSE: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 shareholder) when the 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.

ConocoPhillips (NYSE:COP) is our play of choice for the following reasons:

  • It has a splendid levered free cash flow: 8 93 billion.
  • A massive levered free cash flow of $8.93 billion.
  • Net income has soared from $4.4 billion in 2009 to $12.4 billion in 2011.
  • Total cash flow from operating activities has increased from $12.4 billion in 2009 to $19.6 billion in 2011.
  • It has a great long-term debt to equity ratio of 0.33.
  • A great quarterly earnings growth rate of 66%.
  • A great interest rate coverage ratio of 24.6.
  • A 3 year dividend growth rate of 12%.
  • A low payout ratio of 29%.
  • A great three year total return of 107%.
  • A stellar dividend history; it has been paying dividends since 1934.
  • It has consecutively increased dividends for 11 years.
  • A decent quarterly revenue growth rate of 17%.
  • A splendid free cash flow yield of 11%.
  • $100k invested for 10 years would have grown to $377K.

Covered call strategy for ConocoPhillips

ConocoPhillips faces pretty strong resistance in the 80-82 ranges. Traders could thus put the following strategy into play. Sell the August 80 calls. They are currently trading in the $1.56-$1.60 ranges. Let's assume we are able to sell them for $1.58.


Once you sell the calls $1.58 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 80, then your shares will be called, and you will be paid 80 per share. Your total gain will be roughly $4.02 plus the $1.58 premium you were paid per call for a gain of 7.3% based on today's price of $75.98. This is roughly 250% or so above the official inflation rate. 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 80, then you get to keep the premium of $1.58. 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.

Many ratios will be used in this article and investors would do well to get a handle on some of the more important ones which are covered below.

Long-term debt-to-equity ratio is the total long term debt divided by the total equity. The amount of long-term debt a company carries on its balance sheet is very important for it indicates the amount of money a company owes that it doesn't expect to pay off in the next year. A balance sheet that illustrates that long term debt has been decreasing for a few years is a sign that the company is doing well. When debt levels fall, and cash levels increase the balance sheet is said to be improving and vice versa. If a company has too much debt on its books, it could end up being overwhelmed with interest payments and risk having too little working capital which could in the worst case scenario lead to bankruptcy.

Operating cash flow is generally a better metric than earnings per share because a company can show positive net earnings and still not be able to properly service its debt. The cash flow is what pays the bills.

The payout ratio tells us what portion of the profit is being returned to investors. A payout ratio over 100% indicates that the company is paying out more money to shareholders than they are making. This situation cannot last forever. In general if the company has a high operating cash flow and access to capital markets, they can keep this going on for a while. As companies usually only pay the portion of the debt that is coming due and not the whole debt. This technique/trick can technically be employed to maintain the dividend for some time. If the payout ratio continues to increase, the situation warrants close monitoring as this cannot last forever. If your tolerance for risk is a low, look for similar companies with the same or higher yields, but with lower payout ratios. Individuals searching for other ideas might find this article to be of interest - 5 Covered Calls: Atlas Pipeline Partners Is Best Of the Breed.

Current Ratio is obtained by dividing the current assets by current liabilities. This ratio allows you to see if the company can pay its current debts without potentially jeopardizing their future earnings. Ideally the company should have a ratio of 1 or higher.

Price to free cash flow is obtained by dividing the share price by free cash flow per share. Higher ratios are associated with more expensive companies and vice versa. Lower ratios are generally more attractive. If a company generated $400 million in cash flow and then spent $100 million on capital expenditure, then its free flow is $300 million. If the share price is 100 and the free cash flow per share are $5, then company trades at 20 times-free cash flow. This ratio is also useful because it can be used as a comparison to the average within the industry. This gives you an idea of how the company you are interested in holds up to the other companies within the industry.

Interest coverage is usually calculated by dividing the earnings before interest and taxes for a period of one year by the interest expenses for the same time period. This ratio informs you of a company's ability to make its interest payments on its outstanding debt. Lower interest coverage ratios indicate that there is a larger debt burden on the company and vice versa. For example if a company has an interest ratio of 11.8, this means that it covers interest expenses 11.8 times with operating profits.

Inventory turnover is calculated by dividing sales by inventory. If a company generated $30 million in sales and had an average inventory of $6 million, the inventory turn over would be equal to 5. This value indicates that there are five inventory turnovers per year. This means that it takes roughly 2.4 months to sell the inventory. A low inventory turnover is a sign of inefficiency and vice versa.

Price to tangible book is obtained by dividing share price by tangible book value per share. The ratio gives investors some idea of whether they are paying too much for what would be left over if the company were to declare bankruptcy immediately. In general stocks that trade at a higher price to tangible book value could leave investors facing a great percentage per share loss than those that trade at lower ratios. The price to tangible book value is theoretically the lowest possible price the stock would trade to. Additional key metrics are addressed in this article - 5 Interesting Stocks: 3 To Buy And 2 To Take Or Leave.

ConocoPhillips

Industry: Refining and Marketing

Growth

  1. Net income for the past three years
  2. Net Income ($mil) 2009 = $4414
  3. Net Income ($mil) 2010 = $11358
  4. Net Income ($mil) 2011 = $12436
  1. Total cash flow from operating activities
  2. 2009 = $12.48 billion
  3. 2010 = $17.05 billion
  4. 2011 = $19.65 billion

Performance

  1. Price to Sales = 0.39
  2. Price to Book = 1.56
  3. Price to Tangible Book = 1.61
  4. Price to Cash Flow = 4.98
  5. Price to Free Cash Flow = 35.9
  1. Quick Ratio = 0.91
  2. Current Ratio = 1.10
  3. LT Debt to Equity = 0.33
  4. Total Debt to Equity = 0.33
  5. Interest Coverage = 24.6
  6. Inventory Turnover = 29.59
  7. Asset Turnover = 1.64
  8. ROE = 17.8%
  9. Return on Assets = 7.75%
  10. Quarterly Earnings Growth = 66.1%
  11. Total return last 3 years = 107%
  12. Total return last 5 years = 25%

Dividend history and dividend sustainability

  1. Dividend yield 5 year average = 3.3%
  2. Payout ratio = 29%
  3. Dividend growth rate 3 year average = 12.18%
  4. Dividend growth rate 5 year average = N11.66%
  5. Consecutive dividend increases = 11 years
  6. Paying dividends since = 1934

Notes

ConocoPhillips falls under the category of "great."

American Apparel, Inc. (NYSEMKT:APP)

Industry: Apparel, Footwear and Accessories

Levered Free Cash Flow: 4.41M

Net income for the past three years

Net Income 2009 = $1 million

Net Income 2010 = $-86 million

Net Income 2011 = $-39 million

EBITDA 12/2011 = $30 million

EBITDA 12/2010 = $-16 million

EBITDA 12/2009 = $63 million

Net income Reported Quarterly = $8 million

Total cash flow from operating activities

2009 = $45.21 million

2010 = $-32.37 million

2011 = $2.31 million

Cash Flow 12/2011 = 0.04 $/share

Cash Flow 12/2010 = -0.72 $/share

Cash Flow 12/2009 = 0.52 $/share

Annual EPS before NRI 12/2011 = -0.32

Annual EPS before NRI 12/2010 = -1.2

Annual EPS before NRI 12/2009 = 0.01

Annual EPS before NRI 12/2008 = 0.2

Annual EPS before NRI 12/2007 = 0.31

ROE = -101.34%

Return on Assets = -15.99%

Quarterly Revenue Growth = 9.5%

Key Ratios

Price to Sales = 0.17

Price to Book = 1.87

Price to Tangible Book = 2.18

Price to Cash Flow = 22.27

Price to Free Cash Flow = -10.4

Current Ratio 09/2011 = 1.61

Current Ratio 5 Year Average = 1.57

Quick Ratio = 0.31

Cash Ratio = 0.13

Interest Coverage = N/A

Total return last 3 years = -72.76%

Total return last 5 years = -92.15%

Notes

This would fall under the below average category and we would avoid this play. Net income, EBITDA and cash flow per share have all been dropping. It also sports very weak quick and cash ratios.

Blackstone Group LP (NYSE:BX)

Industry: Wealth Management

Free Cash Flow: $360 million

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $-715 million
  3. Net Income 2010 = $-370 million
  4. Net Income 2011 = $-168 million
  1. EBITDA 12/2011 = $343 million
  2. EBITDA 12/2010 = $-319 million
  3. EBITDA 12/2009 = $-2120 million
  4. Net income Reported Quarterly = $21 million
  1. Total cash flow from operating activities
  2. 2009 = $411.51 million
  3. 2010 = $-371.89 million
  4. 2011 = $1.1 billion
  1. Cash Flow 12/2011 = 3.2 $/share
  2. Cash Flow 12/2010 = 2.68 $/share
  3. Cash Flow 12/2009 = 1.82 $/share
  1. Annual EPS before NRI 12/2011 = 1.25
  2. Annual EPS before NRI 12/2010 = 1.46
  3. Annual EPS before NRI 12/2009 = 0.63
  4. Annual EPS before NRI 12/2008 = -1.03
  5. Annual EPS before NRI 12/2007 = 1.62

Performance

  1. ROE = 11.93%
  2. Return on Assets = 4.57%
  3. Quarterly Revenue Growth = -16.6%
  1. Price to Book = 0.66
  2. Price to Tangible Book = 1.59
  3. Price to Cash Flow = 4.8
  4. Price to Free Cash Flow = -28.2
  5. Current Ratio 09/2011 = 0.78
  6. Current Ratio 5 Year Average = 0.85
  7. Quick Ratio = 0.78
  8. Cash Ratio = 0.44
  9. Interest Coverage 09/2011 = 44.94
  10. Total return last 3 years = 183.81%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.33
  2. Payout Ratio 06/2011 = 0.31
  3. Payout Ratio 5 Year Average 09/2011 = 0.9
  4. Change in Payout Ratio = -0.58
  1. Dividend yield 5 year average = 6.3%
  2. Dividend growth rate 3 year Average = -10.38%
  3. Dividend growth rate 5 year average = 0%
  4. Consecutive dividend increases = 1 years
  5. Paying dividends since = 2007

Notes

This would fall under the category of average. Net income is still negative though the losses have been narrowing over the past three years, cash flow per share is rising and EBITDA turned positive in 2011. Investors willing to take on some risk could be well rewarded. However in our opinion this play is not for long term investors as there are many other plays that offer similar or higher yields with less risk.

RAIT Financial Trust (NYSE:RAS)

Industry: REITs

Cash Flow: $-18.9 million

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $-428 million
  3. Net Income 2010 = $112 million
  4. Net Income 2011 = $-37 million
  1. EBITDA 12/2011 = $83 million
  2. EBITDA 12/2010 = $238 million
  3. EBITDA 12/2009 = $-150 million
  4. Net income Reported Quarterly = $21 million
  1. Total cash flow from operating activities
  2. 2009 = $65.02 million
  3. 2010 = $15.45 million
  4. 2011 = $-2.02 million
  1. Cash Flow 12/2011 = 1.19 $/share
  2. Cash Flow 12/2010 = 1.69 $/share
  3. Cash Flow 12/2009 = 1.56 $/share
  1. Annual EPS before NRI 12/2011 = 0.05
  2. Annual EPS before NRI 12/2010 = 0.42
  3. Annual EPS before NRI 12/2009 = -0.18
  4. Annual EPS before NRI 12/2008 = 5.52
  5. Annual EPS before NRI 12/2007 = -2.55

Performance

  1. ROE = 2.8%
  2. Return on Assets = 0.87%
  3. Quarterly Revenue Growth = 3.3%
  1. Key Ratios
  2. Price to Sales = 1.12
  3. Price to Book = 0.23
  4. Price to Tangible Book = 0.25
  5. Price to Cash Flow = 4.41
  6. Price to Free Cash Flow = -4.7
  1. Current Ratio 09/2011 = 8.02
  2. Current Ratio 5 Year Average = 3.44
  3. Quick Ratio = 8.02
  4. Cash Ratio = 7.11
  5. Interest Coverage 09/2011 = 0.72
  6. Total return last 3 years = 45.83%
  7. Total return last 5 years = -84.12%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.49
  2. Payout Ratio 06/2011 = 0.35
  3. Payout Ratio 5 Year Average 09/2011 = 0.37
  4. Payout Ratio 5 Year Average 06/2011 = 0.43
  5. Change in Payout Ratio = 0.13
  1. Dividend yield 5 year average = 21.7%

Notes

This would fall under the category of "average."

Northstar Realty Finance Corp (NYSE:NRF)

Industry: REITs

Free Cash Flow: $187K

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $-130 million
  3. Net Income 2010 = $-375 million
  4. Net Income 2011 = $-242 million
  1. EBITDA 12/2011 = $-346 million
  2. EBITDA 12/2010 = $-435 million
  3. EBITDA 12/2009 = $-127 million
  4. Net income Reported Quarterly = $21 million
  1. Total cash flow from operating activities
  2. 2009 = $54.52 million
  3. 2010 = $35.56 million
  4. 2011 = $64.14 million
  1. Cash Flow 12/2011 = 0.47 $/share
  2. Cash Flow 12/2010 = -4.34 $/share
  3. Cash Flow 12/2009 = 1.1 $/share
  1. Annual EPS before NRI 12/2011 = 1
  2. Annual EPS before NRI 12/2010 = -4.17
  3. Annual EPS before NRI 12/2009 = 0.45
  4. Annual EPS before NRI 12/2008 = 1.5
  5. Annual EPS before NRI 12/2007 = 0.51

Performance

  1. ROE = 15.54%
  2. Return on Assets = 2.63%
  1. Key Ratios
  2. Price to Sales = 1.12
  3. Price to Book = 0.64
  4. Price to Tangible Book = 0.71
  5. Price to Cash Flow = 11.24
  6. Price to Free Cash Flow = -4.4
  1. Current Ratio 09/2011 = 0.37
  2. Current Ratio 5 Year Average = 0.62
  3. Quick Ratio = 0.37
  4. Cash Ratio = 0.33
  5. Interest Coverage 03/2012 = N/A
  6. Total return last 3 years = 192.44%
  7. Total return last 5 years = -40.09%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.45
  2. Payout Ratio 5 Year Average 09/2011 = 4.24
  3. Payout Ratio 5 Year Average 06/2011 = 4.35
  4. Change in Payout Ratio = -3.8
  1. Dividend yield 5 year average = 20.6%
  2. Dividend growth rate 3 year Average = -18.31%
  3. Dividend growth rate 5 year average = -10.19%
  4. Consecutive dividend increases = 1 years
  5. Paying dividends since = 2005

Notes

This would fall under the category of "average-good."

Conclusion

The markets are rather overbought and long term investors would do well to wait for a strong pullback before committing large sums of money to this market. Selling covered calls thus is a great way to earn extra income while you wait for this pullback to materialize.

EPS, EPS surprise, broker recommendations and price and consensus charts sourced from zacks.com. A significant portion of the historic data was obtained from zacks.com. Option table sourced from yahoofinance.com. Earnings 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.

Additional disclosure: 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 Call Plays Ranging From Excellent To Run Of The Mill