Chesapeake Energy (CHK) is down almost 50% from its 52-week high. The latest bad news surrounding the company was that the company's CEO McClendon borrowed $1.1 billion in the last three years in an interesting way.
According to the documents, the CEO is able to invest in 2.5% of every well operated by the company. Of course, the borrowing was done by using his stakes in these wells as collateral. The executives of Chesapeake Energy claim that this deal will not hurt the company in any way and it will not lead to conflicts of interest, as it only concerns Mr. McClendon's personal finances. Still, this gave investors enough reason to panic as the company was already suffering due to really cheap natural gas in the last year.
The good news is that investors that don't currently own this company can turn this panic mode into a big advantage. Those who buy the stock at reduced price at the moment and sell covered options have the potential to profit greatly from this trade. Keep in mind that the company's current P/E ratio is only 8 and many of the potentially bad things that might or might not happen to the company are already baked in the price. I don't expect much more bad news to come out of this company for a while.
Currently, the market price of Chesapeake Energy is $17.70. Personally, I like selling in the money calls, as long as they are not too deep in the money. What if we wanted to buy a few hundred CHK stocks and sold covered calls for these stocks with a strike price of $17. If our expiration date is April, we are looking at a premium of $1.05. If our expiration date is May, we are looking at a premium of $1.73. If our expiration date is July, we are looking at a premium of $2.38. Move the expiration date to October and the premium increases to $2.72 and for next January, the premium is $3.60.
If the stock price ends above $17 by the expiration date, our profit will be 1.98% for expiration date of April; pretty nice for only a few days. In the same situation, our profit will be 5.82% for expiration date of May. For July expiration, the profit is 9.49%, for October expiration, the profit is 11.42% and for January expiration, the profit is 16.39%.
If the price falls below $17.00, we will keep more of the premium and be able to sell more calls for these stocks. The ideal situation would be presented if the stock price was $16.99 by the time of expiration so that the seller of the call could keep all of the premium and the stock. I will personally sell covered calls expiring next May at a strike price of $17.00. As a rule of thumb, selling monthly calls will generate a higher yield at the end of the year than selling one call that expires by the end of the year; however, keep in mind that taxes and commissions may eat into some of this yield.
I believe that Chesapeake Energy is oversold due to investors panicking too much in the last year. The company also has a dividend yield of 1.82%, which can also be added to the equation. As for buying options of this company, I would buy calls slightly out of money with the long-term horizon. For example, a call with a strike price of $18.00-$20.00 and expiration date of next January can give you enough room to operate while avoiding very high premiums.
In the long run, Chesapeake Energy should deliver good results to patient investors. However, in the short run, I would avoid just buying and holding the stock without selling calls to protect one from further downside.
Disclosure: I am long CHK.
Additional disclosure: I'm selling covered calls with a strike price of $17 and expiration date of May as of right now.