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"Two things are infinite: the universe and human stupidity; and I'm not sure about the the universe."

Albert Einstein

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 shareholder 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 SDRL, which is currently trading at 38, 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 SDRL does not trade above 45 (usually the stock has to trade above the strike price on the last trading day), 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 is 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 share holder) 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.

Prudential Financial, Inc. (PRU) is our play of choice for the following reasons:

  • A very strong levered free cash flow of $5.27 billion.
  • Net income increased from $3.1 billion in 2009 to $3.66 billion in 2011.
  • EBITDA surged from $1.6 billion in 2009 to $5.4 billion in 2011.
  • Sales increased from $2.7 billion in 2009 to $3.9 billion in 2011.
  • Cash flow per share rose from $5.79 in 2009 to $7.29 in 2011.
  • It has a very strong quarterly earnings growth rate of 287%.
  • A great quarterly revenue growth rate of 45%.
  • A high beta of 2.11 which makes it a good candidate for covered writes.
  • A decent five year dividend growth rate of 6.8%.
  • It has projected 3-5 year EPS growth rate of 9%.
  • A very strong free cash flow yield of 41%.
  • A strong three year total return of 197%.
  • 100K invested for 10 years would have grown to $222K; if dividends were reinvested the rate of return would be higher.

Covered calls strategy for Prudential Financial, Inc.

Prudential Financial, Inc faces pretty strong level of resistance in the 65 ranges. One way to play this would be to sell the Sept 70 calls. They are currently trading in the $1.99-$2.06 ranges. Taking the midway point, let us assume we sold them at $2.03.

Once you sell the contract, $203 will be deposited in your account (100X2.03). If the stock trades past 70, then your shares will be called, and you will be paid $70 per share.

Your total gain= $6.41 plus the $2.03 premium you received per share, which works out to a gain of 13.6% based on Fridays closing price of $63.39.

If the stock does not trade above 70, you get to keep the premium which works out to a gain of roughly 3.2%. If your shares are called you still walk away with a nice gain and if you choose, you can repeat the whole process again.

Other variations for more aggressive players

Another option is to buy the call back if it drops significantly. Let's say the call drops from $2.03 to $1.00 then one could purchase the call back and then start the whole process again. For example if the stock has dropped from down to 61 one could sell calls that command higher premiums.

As many ratios are going to be used in this article, it would be in the investors best interest to get a handle on some of the more important ones. It could prove to be very helpful in the selection process.

"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 then 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 sometime. 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 Splendid Long-Term Growth Plays.

"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 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.

"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 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 Covered Call Plays: 2 Great, 2 Good And 1 To Take or leave.

Company: Prudential Financial, Inc.

Levered Free Cash Flow = 5.27B

Basic Key ratios

  1. Percentage Held by Insiders = 0.12
  2. Number of Institutional Sellers 12 Weeks = 1

Growth

  1. Net Income ($mil) 12/2011 = 3666
  2. Net Income ($mil) 12/2010 = 3195
  3. Net Income ($mil) 12/2009 = 3124
  4. 12months Net Income this Quarterly/ 12months Net Income 4Q's ago = 30.1
  5. Quarterly Net Income this Quarterly/ same Quarter year ago = 184.51
  1. EBITDA ($mil) 12/2011 = 5407
  2. EBITDA ($mil) 12/2010 = 4288
  3. EBITDA ($mil) 12/2009 = 1699
  4. Net Income Reported Quarterlytr ($mil) = 606
  5. Annual Net Income this Yr/ Net Income last Yr = 14.74
  6. Cash Flow ($/share) 12/2011 = 7.29
  7. Cash Flow ($/share) 12/2010 = 5.91
  8. Cash Flow ($/share) 12/2009 = 5.79
  1. Sales ($mil) 12/2011 = 39397
  2. Sales ($mil) 12/2010 = 30982
  3. Sales ($mil) 12/2009 = 27740
  1. Annual EPS before NRI 12/2007 = 7.54
  2. Annual EPS before NRI 12/2008 = 2.69
  3. Annual EPS before NRI 12/2009 = 5.58
  4. Annual EPS before NRI 12/2010 = 6.27
  5. Annual EPS before NRI 12/2011 = 6.41

Dividend history

  1. Dividend Yield = 2.31
  2. Dividend Yield 5 Year Average =1.90%
  3. Annual Dividend 12/2011 = 1.45
  4. Annual Dividend 12/2010 = 1.15
  5. Forward Yield = 2.31
  6. Dividend 5 year Growth =6.8%

Dividend sustainability

  1. Payout Ratio 06/2011 = 0.23
  2. Payout Ratio 5 Year Average 06/2011 = 0.17
  3. Change in Payout Ratio = 0.06

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = -2.97
  2. Next 3-5 Year Estimate EPS Growth rate = 9
  3. EPS Growth Quarterly(1)/Q(-3) = -110.67
  4. ROE 5 Year Average 06/2011 = 13.09
  5. Return on Investment 06/2011 = 5.23
  6. Debt/Total Cap 5 Year Average 06/2011 = 43.23
  1. Current Ratio 06/2011 = 0.17
  2. Current Ratio 5 Year Average = 0.24
  3. Quick Ratio = 0.17
  4. Cash Ratio = 0.16
  5. Interest Coverage Quarterly = 1.05

Valuation

  1. Book Value Quarterly = 80.45
  2. Price/ Book = 0.78
  3. Price/ Cash Flow = 8.63
  4. Price/ Sales = 0.75
  5. EV/EBITDA 12 Mo = 1.07

Notes

It would fall under the category of "great/excellent."

AFLAC Inc. (NYSE:AFL)

Industry: Life and Health

Levered Free Cash Flow: 2.47B

Beta=2.19

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $1497 million
  3. Net Income 2010 = $2344 million
  4. Net Income 2011 = $1964 million
  1. EBITDA 12/2011 = $3188 million
  2. EBITDA 12/2010 = $3734 million
  3. EBITDA 12/2009 = $2307 million
  4. Net income Reported Quarterly = $8 million
  1. Total cash flow from operating activities
  2. 2009 = $6.17 billion
  3. 2010 = $6.99 billion
  4. 2011 = $10.85 billion
  1. Cash Flow 12/2011 = 6.37 $/share
  2. Cash Flow 12/2010 = 5.55 $/share
  3. Cash Flow 12/2009 = 4.87 $/share
  1. Annual EPS before NRI 12/2011 = 6.33
  2. Annual EPS before NRI 12/2010 = 5.53
  3. Annual EPS before NRI 12/2009 = 4.85
  4. Annual EPS before NRI 12/2008 = 3.99
  5. Annual EPS before NRI 12/2007 = 3.27

Performance

  1. ROE = 24.16%
  2. Return on Assets = 2.71%
  3. Quarterly Earnings Growth = 24.9%
  4. Quarterly Revenue Growth = 12.4%
  1. Key Ratios
  2. Price to Sales = 0.96
  3. Price to Book = 1.58
  4. Price to Tangible Book = 1.58
  5. Price to Cash Flow = 7.18
  6. Price to Free Cash Flow = 2.1
  1. Current Ratio 09/2011 = 0.04
  2. Current Ratio 5 Year Average = 0.17
  3. Quick Ratio = 0.04
  4. Cash Ratio = 0.02
  5. Interest Coverage 09/2011 = 16.74
  6. Total return last 3 years = 149%
  7. Total return last 5 years = 9%

Dividend history and sustainability

  1. Payout Ratio 09/2011 = 0.21
  2. Payout Ratio 06/2011 = 0.19
  3. Payout Ratio 5 Year Average 09/2011 = 0.24
  4. Payout Ratio 5 Year Average 06/2011 = 0.24
  5. Change in Payout Ratio = -0.03
  1. Dividend yield 5 year average = 2.8%
  2. Dividend growth rate 3 year Average = 8%
  3. Dividend growth rate 5 year average = 16%
  4. Consecutive dividend increases = 29 years
  5. Paying dividends since = 1973

Notes

It falls under the category of "great/excellent."

Company: Nexen Inc (NXY)

Levered Free Cash Flow = 1.25B

Basic Key ratios

  1. Percentage Held by Insiders = 0.17

Growth

  1. Net Income ($mil) 12/2011 = 705
  2. Net Income ($mil) 12/2010 = 1162
  3. Net Income ($mil) 12/2009 = 489
  4. 12months Net Income this Quarterly/ 12months Net Income 4Q's ago = -31.68
  5. Quarterly Net Income this Quarterly/ same Quarter year ago = -79.81
  1. EBITDA ($mil) 12/2011 = 3680
  2. EBITDA ($mil) 12/2010 = 3008
  3. EBITDA ($mil) 12/2009 = 993
  4. Net Income Reported Quarterlytr ($mil) = 43
  5. Annual Net Income this Yr/ Net Income last Yr = -39.31
  6. Cash Flow ($/share) 12/2011 = 5.19
  7. Cash Flow ($/share) 12/2010 = 4.13
  8. Cash Flow ($/share) 12/2009 = 0.98
  1. Sales ($mil) 12/2011 = 6483
  2. Sales ($mil) 12/2010 = 5657
  3. Sales ($mil) 12/2009 = 5556
  1. Annual EPS before NRI 12/2007 = 2.46
  2. Annual EPS before NRI 12/2008 = 3.55
  3. Annual EPS before NRI 12/2009 = 0.97
  4. Annual EPS before NRI 12/2010 = 1.05
  5. Annual EPS before NRI 12/2011 = 1.47

Dividend history

  1. Dividend Yield = 1.07
  2. Dividend Yield 5 Year Average =0.8%
  3. Annual Dividend 12/2011 = 0.2
  4. Annual Dividend 12/2010 = 0.19
  5. Forward Yield = 1.07
  6. 5 year dividend growth rate= 21.7%
  1. Dividend sustainability
  1. Payout Ratio 06/2011 = 0.14
  2. Payout Ratio 5 Year Average 06/2011 = 0.11
  3. Change in Payout Ratio = 0.03

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = -28.15
  2. Next 3-5 Year Estimate EPS Growth rate = 7
  3. EPS Growth Quarterly(1)/Q(-3) = -170
  4. ROE 5 Year Average 06/2011 = 17.26
  5. Return on Investment 06/2011 = 6.3
  6. Debt/Total Cap 5 Year Average 06/2011 = 43.63
  1. Current Ratio 06/2011 = 1.08
  2. Current Ratio 5 Year Average = 1.36
  3. Quick Ratio = 0.98
  4. Cash Ratio = 0.33
  5. Interest Coverage =7.9%

Valuation

  1. Book Value Quarterly = 16.05
  2. Price/ Book = 1.17
  3. Price/ Cash Flow = 3.61
  4. Price/ Sales = 1.36
  5. EV/EBITDA 12 Mo = 3.65

Notes

It would fall under the category of "good."

ATP Oil & Gas Corp (ATPG)

Industry: Production and Extraction

Levered Free Cash Flow: -23.01M

Beta=3.28

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $-49 million
  3. Net Income 2010 = $-338 million
  4. Net Income 2011 = $-192 million
  1. EBITDA 12/2011 = $493 million
  2. EBITDA 12/2010 = $79 million
  3. EBITDA 12/2009 = $107 million
  4. Net income Reported Quarterly = $8 million
  1. Total cash flow from operating activities
  2. 2008 = $546.97 million
  3. 2009 = $159.83 million
  4. 2010 = $-37.28 million
  1. Cash Flow 12/2011 = 3.54 $/share
  2. Cash Flow 12/2010 = 3.23 $/share
  3. Cash Flow 12/2009 = 2.3 $/share
  1. Annual EPS before NRI 12/2011 = -2.93
  2. Annual EPS before NRI 12/2010 = -1.21
  3. Annual EPS before NRI 12/2009 = -0.16
  4. Annual EPS before NRI 12/2008 = 2.98
  5. Annual EPS before NRI 12/2007 = 2.97

Performance

  1. Return on Assets = -3.61%
  2. Quarterly Revenue Growth = 25.4%
  3. Price to Sales = 0.62
  4. Price to Tangible Book = -3.35
  5. Price to Cash Flow = 2.3
  6. Price to Free Cash Flow = -1.4
  1. Current Ratio 09/2011 = 0.35
  2. Current Ratio 5 Year Average = 0.96
  3. Quick Ratio = 0.35
  4. Cash Ratio = 0.22
  5. Interest Coverage 09/2011 = 0.57
  1. Total return last 3 years = 129.75%
  2. Total return last 5 years = -78.48%

Notes

It falls under the category of "average-good."

Duke Energy Corp (NYSE:DUK)

Industry: Electric Utilities

Levered Free Cash Flow: -1.11B

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $1075 million
  3. Net Income 2010 = $1320 million
  4. Net Income 2011 = $1706 million
  1. EBITDA 12/2011 = $5350 million
  2. EBITDA 12/2010 = $5044 million
  3. EBITDA 12/2009 = $4428 million
  4. Net income Reported Quarterly = $288 million
  1. Total cash flow from operating activities
  2. 2009 = $3.47 billion
  3. 2010 = $4.52 billion
  4. 2011 = $3.68 billion
  1. Cash Flow 12/2011 = 2.98 $/share
  2. Cash Flow 12/2010 = 2.93 $/share
  3. Cash Flow 12/2009 = 2.63 $/share
  1. Annual EPS before NRI 12/2011 = 1.46
  2. Annual EPS before NRI 12/2010 = 1.43
  3. Annual EPS before NRI 12/2009 = 1.22
  4. Annual EPS before NRI 12/2008 = 1.21
  5. Annual EPS before NRI 12/2007 = 1.25

Performance

  1. ROE = 8.49%
  2. Return on Assets = 3.2%
  3. Quarterly Earnings Growth = -32.6%
  4. Quarterly Revenue Growth = -2.3%
  1. Price to Sales = 1.97
  2. Price to Book = 1.25
  3. Price to Tangible Book = 1.54
  4. Price to Cash Flow = 7.2
  5. Price to Free Cash Flow = -13.6
  1. Current Ratio 09/2011 = 1.25
  2. Current Ratio 5 Year Average = 1.25
  3. Quick Ratio = 0.96
  4. Cash Ratio = 0.61
  5. Interest Coverage 09/2011 = 2.83

Dividend history and sustainability

  1. Payout Ratio 09/2011 = 0.69
  2. Payout Ratio 06/2011 = 0.7
  3. Payout Ratio 5 Year Average 09/2011 = 0.69
  4. Payout Ratio 5 Year Average 06/2011 = 0.69
  5. Change in Payout Ratio = -0.01
  1. Dividend yield 5 year average = 5.4%
  2. Dividend growth rate 3 year average = 3.00%
  3. Dividend growth rate 5 year average = 2.26%
  4. Paying dividends since = 1926
  5. Total return last 3 years = 67%
  6. Total return last 5 years = 21%

Notes

Duke Energy would fall under the category of "good."

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

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

Additional disclosure: 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. Free cash flow yield, income from cont operations, and revenue growth sourced from Ycharts.com.

Source: 5 Covered Writes: 2 Excellent, 2 Good And 1 Middling