I think EnCana (NYSE:ECA), The Little Energy Stock that Could, is a good pick for income investors as it currently yields 3.6%-- but it could be even better. We'd like to suggest that as nice as EnCana's dividend yield is, a nimble income investor can get about two or three times that yield on a regular basis by writing (selling) call options on the EnCana stock that they own.
A guy from the South merged onto a highway and got into an accident with a guy from the North. When the Northerner asked the Southerner why he didn't yield, the Southerner said "I yield as loud as I could!"
And so it is with EnCana, we like its yield but we want it to yield as loud as it can, or if you will, as loud as it EnCana.
Writing Covered Calls
First let's understand what a call option is. A call option is the right but not the obligation to buy a share of stock at an agreed upon price until an agreed upon date. The agreed upon price is the "strike" and the date that the rights end is the "expiration." Call options are depreciating assets, all things being equal. Part of the value of an option is how much time it has until it expires and that means options lose value over time even as the underlying stock stays unchanged.
Most non-professional investors never consider writing (selling) options and this is a shame because being on the buying side means time is always working against you. If you are the seller, time is always working for you. Nice work if you can get it. This is probably the most important lesson an investor new to options can recognize - it is usually better to be the seller than the buyer of options.
So essentially what we are doing is selling someone the right to buy our shares of ECA from us at a price higher than the shares currently trade. Let's look at an example. Let's say Jane owns 1 share of ECA and it currently trades at $10. Louis Gossett Jr thinks ECA is an average investment but suspects it might get bought out at a hefty premium. He agrees to pay Jane $1 for the right to buy her share of ECA for $11 between now and the end of the year. Jane keeps that $1 whether Louis Gossett Jr exercises the call or not. If he does not then the fee that Jane got was "free" money and she continues to collect ECA's dividend. If Louis Gossett Jr. does exercise the call then Jane still keeps the original $1, sells ECA at a $1 profit ($11-$10), and keeps any dividends paid up until she sells. Not bad.
In this strategy Jane sells an OTM call. When the stock trades at a price lower than the strike, then the call option is OTM (out of the money). ITM (in the money) means the stock is trading higher than the strike price and the call has "intrinsic value." ATM (at the money) means it is at or around the strike. You see the acronyms OTM, ITM, and ATM all the time in options discussions.
Options like this also trade in lots of 100. So in the above example if a call costs $1 it really costs $100 and you get the right to buy 100 shares. Prices, however, are usually quoted per share. Also, in this case the call option is said to be "covered" because Jane owns the shares she may be called on to sell as opposed to "naked" if she did not own the shares.
The Sound of a Man Working on an Options Chain
Have a look at ECA's options chain, a list of the puts (not discussed here) and calls available for ECA. (Source ETrade)
Let's look at the $24 call. It has a bid at $1.40. This means that someone is willing to pay us $140 for the right to buy our hypothetical 100 shares at a price of $24/share between now and January 19 2013. That $140 is 6.5% of the $2,168 present value of 100 shares of ECA. This trade takes 7 months, that 6.5% comes to 11.1% annually. Add that to the 3.6% dividend and we get 14.7%. For Income investors, writing covered calls can be a deal too good to pass up.
It's not all kicks and giggles though. There are two important potential downsides of writing covered calls: Liquidity and upside-capping. Let's look at them.
When we sell a call, we have opened a trade. So we now have to hold on to our shares of EnCana because we gave someone else the right to buy them from us. If we decide that EnCana's prospects have dimmed and we want to sell the stock, we have to close the call out before we can sell. In order to do that we have to buy the same call that we sold, flattening out the trade. Looking at the options chain, there is an "ask" for $1.50 on the $24 call, so we may have to pay $150 for something we just sold for $140. The difference between these two is called the "spread." In a more liquid market there might be buyers and sellers at $1.45, but as it is we have to sell low and buy high if we want out.
The second potential drawback of writing covered calls is capping upside. If EnCana gets bought out by Exxon (NYSE:XOM) tomorrow for $40 a share, we still have to sell for $24. This is the tradeoff between income and potential growth and it is for this reason that it is important to pick a strike price that you would be happy to sell at. In this case ECA trades now at $21.68 so if we sold at $24 that would be a 10.7% gain on top of the $140 and any dividends. For most income investors, the "downside" of upside-capping should be an acceptable tradeoff.
This strategy of writing covered calls for income is one of the best ways to build a larger yield on a stock. For investors that understand the risks of liquidity and upside-capping, this strategy is a powerful tool for increasing income. We will call this the "Yield as Loud as You EnCana" trade and we will follow its fate as the trade progresses to see what we can learn.
Energy stocks you might consider using this covered calls strategy with include: Arch Coal Inc (NYSE:ACI), Alpha Natural Resources, Inc.(NYSE:ANR), Apache Corporation (NYSE:APA), Baker Hughes Incorporated (NYSE:BHI), Peabody Energy Corporation (NYSE:BTU),Chesapeake Energy Corporation (NYSE:CHK), ConocoPhillips(NYSE:COP), Chevron Corporation (NYSE:CVX), Devon Energy Corporation (NYSE:DVN), Enbridge Energy Partners, L.P.(NYSE:EEP), EOG Resources, Inc. (NYSE:EOG), Halliburton Company(NYSE:HAL), Hess Corp. (NYSE:HES), Linn Energy, LLC(NASDAQ:LINE), Marathon Oil Corporation (NYSE:MRO), National-Oilwell Varco, Inc. (NYSE:NOV), Plains All American Pipeline, L.P.(NYSE:PAA), Petroleo Brasileiro SA (ADR) (NYSE:PBR), Penn West Petroleum Ltd (NYSE:USA) (NYSE:PWE), Royal Dutch Shell plc (ADR)(NYSE:RDS.A), Seadrill Ltd (NYSE:SDRL), Schlumberger Limited.(NYSE:SLB), Statoil ASA (ADR) (NYSE:STO), Suncor Energy Inc.(NYSE:SU), TOTAL S.A. (ADR) (NYSE:TOT), Valero Energy Corporation (NYSE:VLO), Exxon Mobil Corporation.
Disclosure: I am long ACI.