The strategy of selling a put to purchase calls not only provides you with the opportunity to leverage your position in Southern Company (SO), but it also provides one with the chance to get into the stock at a much lower price. If you are bullish on the stock, this is a great way to leverage your position for a relatively low fee. We recently examined this company in detail, but will provide some of the reasons we listed in the article as to why we think this company makes for a good long term play again.
It is one of the largest and best managed utility companies in the United States, and it has consecutively increased its dividend for 11 years in a row. Its rate of returns is among the highest in the industry, and it is one of the best managed energy firms servicing the Southeast market. Southern also offers a very nice yield of 4.3% and has a strong relative strength score of 81 out of a possible 100.
Management expects to invest $14 billion between 2012 and 2014. The bulk of this capital will be invested in transmission, distribution and generation facilities and this is expected to boost earnings growth through an increase in efficiency and production. Southern is also a leader in Power plant productivity, cost control and new technology research.
The stock has pulled back nicely since topping out in August and has a pretty strong level of support in the 44.50-45.00 ranges. It tested this level on the 31st of August, and it held. The normal course of action is for a stock to tests its lows again (or even trade below them) before a bottom is in place. Ideally, it should drop down to the 44.00-44.50 ranges and then bounce off from there. Consider waiting for a test of these ranges before jumping in. In our opinion, Southern Company makes for a far better play than Pepco Holdings (POM), Exelon Corporation (EXC) and Duke Energy (DUK) as evidenced by the fact that its rate of returns are among the highest in the industry, and it's also a leader in power plant productivity, cost control and new technology research. It is also probably the top energy firm servicing the Southeast market.
Suggested strategy for Southern Company
This play has two parts to it. The first part entails selling a put and in the second part calls are purchased with the proceeds from part 1.
The Feb 2013, 45.00 puts are trading in the $1.54-$1.58 ranges. If the stock pulls back to the stated ranges these puts should trade to the $1.90-$2.00 ranges. We will assume that the put can be sold for $1.90 if the stock trades in the 44.00-44.50 ranges.
The Feb 2013, 48 calls are trading in the $0.47-$0.50 ranges. If the stock pulls back to the stated ranges, these calls should drop down to the $0.30-$0.40 ranges. We will assume that the calls can be purchased for $0.40 or better. For each put sold you will be in a position to purchase up to 4 calls and have a net credit of $30 left over.
Benefits and risks associated with putting this strategy to use
It provides you with the opportunity to significantly leverage your position in this stock for a relatively low cost. You only need to put up $4500 for each put, but you can control up to 400 shares in the process. If you purchased 400 shares today, it would set you back roughly $18,400.
If the stock trades below the strike price you sold the puts at, the shares could be assigned to your account (assignment usually occurs on the last trading day of the option). Depending on the number of calls you purchased your cost per share could range from $43.50 (if you purchased one call only) to $44.70 (if you purchased four calls).
The only real risk is that you have a change of heart and are no longer bullish on the prospects of the stock or feel that the stock could trade well below the strike price you sold the puts at. In this case, you could roll the put, buy back the old puts and sell new out of the money puts.
While the trend is still up the markets are in a volatile phase. Consider closing half the position out if the calls are showing gains in the 60%-100% ranges.
Options tables sourced from yahoofinance.com. Option Profit loss graph sourced from poweropt.com.
It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies - let the buyer beware.