In order to put both parts of this strategy into play you will have to own the stock as we are going to be selling covered calls and puts. Before we go into the details of this strategy, let us examine some of the benefits associated with selling puts and covered calls.
Benefits of selling covered calls
- Income generation
- Downside protection and reduction in portfolio volatility
- Predetermined rate of return
- Converts a common stock into a dividend paying stock
Investors looking for more details on the benefits of selling covered can read our piece on the "Benefits of a Covered Write Strategy."
Benefits associated with selling puts
An investor usually sells a put option if his/her outlook on the underlying security is bullish.
- In essence, you get paid for entering a "limit order" for a stock or stocks you would not mind owning.
- It allows one to generate income in a neutral or rising market.
- Acquiring stocks via short puts is a widely used strategy by many retail traders and is considered to be one of the most conservative option strategies. This strategy is very similar to the covered call strategy.
- The safest option is to make sure the put is "cash secured." This simply means that you have enough cash in the account to purchase that specific stock if it trades below the strike price. Your final price would be a tad bit lower when you add the premium you were paid up front into the equation.
- Every day you profit via time decay as long as the stock price does not drop significantly. In the event it does drop below the strike you sold the put at; you get to buy a stock you like at the price you wanted. Time decay is the greatest in the front month.
Suggested Strategy for Duke Energy (DUK):
The stock topped out around June to July of this year and then proceeded to generate several negative divergence signals when it surged to new highs in July. Negative divergences are generated when the highs were not validated by several technical indicators.
Duke Energy could test the 70.00-71.00 ranges before pulling back and in the process it could put in a lower high, which is generally a bearish development. The long term outlook is still bullish. This is a short to mid term strategy (3-6 months). Currently, it has pretty strong level of support in the 64.00-64.50 ranges, but could trade down to the 62.00 ranges before bottoming. Most stocks that are in a corrective phase tend to temporarily dip below their main up trend lines.
The first part of the transaction entails selling covered calls. The best time to sell covered calls is when a stock is overbought as is the case with Duke Energy.
The Jan 2013 70 calls are trading in the 1.05-1.10 ranges. For this example we will assume that the calls can be sold at 1.05 or better. For each contract sold $105 will be deposited into your account. If the shares do not trade above the strike price you walk away with a gain of 1.5%. If the stock trades above the strike price the calls were sold at, your shares will be called away and you total gain will be 4.07% (1.05 plus the 1.80 gain based on the current price of 68.20)
The Jan 2013 65 puts are trading in the 1.75-1.90 ranges. For this example we will assume that the puts can be sold for 1.80 or better. For each contract sold, $180 will be deposited into your account. If the shares do not trade below the strike price then you walk away with a gain of 2.7%.
Possible outcomes of this strategy
The stock does not trade above the strike price the calls were sold at, nor does it trade below the strike the puts were sold at. In this case, you walk away with a gain of 4.2% (1.5 +2.7).
The stock trades above the strike price the calls were sold at but not below the strike price the puts were sold at. In this case, you walk away with the highest gains, but you also lose your shares. The total return here for seven months would be 6.77% (4.07+2.7).
The stock trades below the strike price the puts were sold at but not above the strike price the calls were sold at. In this case you get into the stock at a lower price of $63.20 and you earn roughly 1.5%.
The stock trades below the strike price the puts were sold at but the shares also trade above the strike price the calls were sold at. In this case you get into the stock at $63.20, your shares are called away and you earn roughly 2.7%.
Benefits of this strategy
The benefit from this strategy is that you now have the chance to open two extra streams of income in addition to the dividend. You also have the chance to get into the stock at a lower price if the stock trades below the strike price the puts were sold at.
The stock could trade above the price you sold the calls at, and you could end up losing your shares. One simple method to avoid this would be to roll the call. Buy back the old call and sell new out of the money calls.
The other risk factor is that the stock trades below the strike price you sold the puts, and the shares are assigned to your account. This should not be a big deal as one only sells puts when one is bullish on the long-term prospects of the stock. If the shares are assigned to your account, you get the chance to get in at a much lower price. If you have a change of heart after selling the puts because you now feel that the stock could trade significantly below the strike price, then you can roll the puts. Buy back the old puts and sell new slightly out of the money puts with more time on them.
Company: Duke Energy Corp (DUK)
- Beta = 0.16
- Operating cash flow = 3.96B
- Levered free cash flow = - 1.42B
- Long term debt to equity = 0.84
- EPS vs 1 year ago = 1.60
- Relative Strength 52 weeks = 84
- Cash Flow 5-year Average = 2.85
- Sales vs quarter 1 year ago = 1.2%
- 5 year sales growth rate = 2.05%
- Net Income ($mil) 12/2011 = 1706
- Net Income ($mil) 12/2010 = 1320
- Net Income ($mil) 12/2009 = 1075
- Net Income Reported Quarterly ($mil) = 295
- EBITDA ($mil) 12/2011 = 5350
- EBITDA ($mil) 12/2010 = 5044
- EBITDA ($mil) 12/2009 = 4428
- Cash Flow ($/share) 12/2011 = 2.98
- Cash Flow ($/share) 12/2010 = 2.93
- Cash Flow ($/share) 12/2009 = 2.63
- Sales ($mil) 12/2011 = 14529
- Sales ($mil) 12/2010 = 14272
- Sales ($mil) 12/2009 = 12731
- Annual EPS before NRI 12/2007 = 1.25
- Annual EPS before NRI 12/2008 = 1.21
- Annual EPS before NRI 12/2009 = 1.22
- Annual EPS before NRI 12/2010 = 1.43
- Annual EPS before NRI 12/2011 = 1.46
- Dividend Yield = 4.5%
- Dividend Yield 5 Year Average = 5.2
- Dividend 5 year Growth = 17
- Payout Ratio = 0.89
- Payout Ratio 5 Year Average = 0.7
- Change in Payout Ratio = -0.01
- Next 3-5 Year Estimate EPS Growth rate = 4.67
- 5 Year History EPS Growth = 2.08
- ROE 5 Year Average = 8.53
- Current Ratio = 1.38
- Current Ratio 5 Year Average = 1.26
- Quick Ratio = 0.96
- Cash Ratio = 0.61
- Interest Coverage = 3.5
For investors looking for other ideas detailed data has been provided Southern Company (SO). Our latest article could also provide some food for thought - Marathon Oil Bulls: A Simple And Low Cost Option to significantly leverage your position.
Company: Southern Company
- Percentage Held by Insiders = 0.49
- Relative Strength 52 weeks = 81
- Profit Margin = 12.8%
- Quarterly Revenue Growth = -7.00%
- Quarterly Earnings Growth = 3.10%
- Beta = 0.13
- 52 week change = 15%
- Sales vs 1 year ago = 1.2
- EPS vs 1 year ago = 3.2
- 5 year sales growth rate = 2.6%
- Sales vs quarter 1 year ago = -7.5%
- Net Income ($mil) 12/2011 = 2268
- Net Income ($mil) 12/2010 = 2040
- Net Income ($mil) 12/2009 = 1708
- Net Income Reported Quarterly ($mil) = 368
- EBITDA ($mil) 12/2011 = 6392
- EBITDA ($mil) 12/2010 = 5792
- EBITDA ($mil) 12/2009 = 5297
- Cash Flow ($/share) 12/2011 = 5.01
- Cash Flow ($/share) 12/2010 = 4.66
- Cash Flow ($/share) 12/2009 = 4.62
- Sales ($mil) 12/2011 = 17657
- Sales ($mil) 12/2010 = 17456
- Sales ($mil) 12/2009 = 15743
- Annual EPS before NRI 12/2007 = 2.24
- Annual EPS before NRI 12/2008 = 2.37
- Annual EPS before NRI 12/2009 = 2.32
- Annual EPS before NRI 12/2010 = 2.37
- Annual EPS before NRI 12/2011 = 2.57
- Dividend Yield = 4.2
- Dividend Yield 5 Year Average = 4.6
- Dividend 5 year Growth = 3.8
- Payout Ratio 03/2012 = 0.77
- Payout Ratio 5 Year Average = 0.74
- Next 3-5 Year Estimate EPS Growth rate = 5.04
- ROE 5 Year Average = 13.53
- Current Ratio = 0.96
- Current Ratio 5 Year Average = 0.98
- Quick Ratio = 0.61
- Cash Ratio = 0.41
- Interest Coverage Quarterly = 3.77
Consider waiting for a test of the 42-44 ranges before committing fresh money to this play as the stock is rather overbought at present.
We suggested a similar strategy to this one very recently on American Capital Agency (AGNC) and it worked out rather well. As the stock is overbought there is a good chance that after initially testing the 70 ranges it could trade as low as 62 before bottoming out. If one really wants to work this option, one could wait for it to trade to 70 and then sell covered calls with strikes at 70 or higher. Close the calls out when and if it pulls back to the 64-65 ranges and sell puts with strikes in the 60-65 ranges.