The best time to sell covered calls is after a stock has had a nice run and there is a good chance that the stock could pull back because it's trading in the overbought ranges. Subsequently, the best time to sell puts is when a stock is undergoing a healthy correction, as it provides you with the chance of getting into a stock you like, at a price of your choosing. The stock we are going to examine today is Silver Wheaton Corp. (SLW). 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. Before we go into the details of this strategy, we are going to provide some reasons to consider this play.
To begin with, Silver Wheaton is the largest metals streaming company in the world. Its 2012, annual attributable production is expected to be roughly 28 million silver equivalent ounces and 42, 000 ounces of gold. This is expected to increase to approximately 48 million silver equivalent ounces and 100,000 ounces of gold by 2016.
Silver Wheaton agreed to acquire a precious metal stream from Hudbay Minerals Inc's (HBM) flagship 777 mine, as well a silver stream from its Constancia mine. These streams are accretive. The 777 mine will increase production by roughly 4.2 million silver equivalent ounces till the end of 2016. The Constancia project is expected to be in full production by 2015. As a result of these two new streams, management has increased its 2016 guidance to roughly 48 million silver equivalent ounces.
Revenues in the second quarter surged to a new record of $201.1 million, an increase of 3% year over year, and attributable silver equivalent production increased by 10% to 6.7 million when compared to the same period one year ago.
Reasons to be bullish on Silver Wheaton :
- A very low long-term debt to equity ratio of 0.02
- A decent levered free cash flow of $312M
- An incredible operating margin of 75%
- A 5 year EPS growth rate of 46%
- A 3-5 year estimated EPS growth rate of 22.99% from Zack's
- A very good retention ratio of 81%
- Net income surged from $118 million in 2009 to $550 million in 2011
- Cash flow per share increased from $0.47 in 2009 to $1.72 in 2011
- Sales increased from 2009 in $239 million in 2009 to $730 million in 2011
- Annual EPS before NRI increased from $0.37 in 2007 to $1.55 in 2011.
- A very low payout ratio of 19%
- An excellent quick and current ratio of 6.3
- Its quarterly dividend payout has risen from $0.03 to $0.10 in about six quarters. Given its fantastic operating margins, there is plenty of room for the dividend to grow
- It does not hedge any of its production. This strategy allows it to benefit from rising silver prices while at the same time reducing the risks faced by traditional mining companies.
- Record Silver equivalent sales of 6.9 million ounces in the 2nd quarter
- It announced attributable proven and probable Silver reserves of 798 million ounces. This is nearly twice the reserves of any other silver company
Charts and Tables of Interest for Silver Wheaton
Click to enlarge
The stock is about to trade above the EPS line and normally when this takes place, the stock tends to trend higher.
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 Writes 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 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.
Silver is still in a long-term bull market and is currently going through a period of consolidation. The current rally is a preview of things to come in the future. Over the next few years, silver will most likely be trading north of $70. The economic uncertainty facing the world today, the threat of another currency crisis and the rampant rate at which the Fed is creating money, provides an ideal back drop for Gold (SPDR Gold Trust ETF: GLD) and Silver (iShares Silver Trust ETF: SLV). Gold and silver thrive in such an environment, and it appears that it's just a matter of time before another currency or economic crisis strikes again. In addition to Silver Wheaton, SLV and Hecla Mining Co. (HL) are two other good ways to play the silver bull market.
Silver Wheaton is currently trading in the overbought ranges and could trade to the $38-$39 ranges before pulling back. A weekly close below $32 should lead to a test of the $28-$30 ranges.
Suggested Strategy for Silver Wheaton
The Jan 2013 38, calls are trading in the $2.45-$2.49 ranges. It should be relatively easy to sell these calls for $2.45 or better. We will assume that the calls can be sold for $2.45. $245 will be deposited into your account for each call sold.
If the shares do not trade above the strike price you walk away with a gain of roughly 6.5% in 4 months. 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 12.5% in months based on the current price of $36.05
We would wait for the stock to test the $32-$33 ranges before selling puts. The Jan 2013, 30 puts are trading in the $1.10-$1.14 ranges. If the stock pulls back to the stated ranges, the puts should trade in the $2.10-$2.40 ranges. For this example, we will assume that the puts can be sold for $2.10 or better. For each contract sold, $210 will be deposited into your account. If the stock trades below the strike price the puts were sold at the shares could be assigned to your account. Your final price per share would be $27.90. If the shares are not assigned to your account, you walk away with a gain of roughly 7.5% in 4 months.
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 14% (7.5 +6.5).
- 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 four months would be 20% (12.5+7.5). The possibility of locking in gains of 20% is well worth the risk of having the shares called away. There are many other great stocks out there that you can get into.
- 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 $27.90 and you earn roughly 6.5%
- 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 $27.90, your shares are called away and you earn roughly 12.5% in 4 months.
Benefits and risks associated with 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. However, given that they are so many good companies out there, this should not be a big deal, especially in this instance where you could earn up to 20% if your shares are called away. You can avoid having your shares called away by rolling the call. Buy back the old call and sell new out of the money calls. The same strategy could be applied to the put if you have a change of heart. Buy back the old puts and sell new slightly out of the money puts with more time on them.
Investors could put both parts of the strategy to play immediately, but you stand to walk away with a larger gain if you want for the stock to pull back to the $32-$33 ranges before you sell the puts. This is a great strategy to lock in a pre-determined rate of profit and at the same time have the opportunity to open up new positions in a stock you like at a lower price.
EPS consensus estimates and EPS surprise charts and some of the Research and historical data used in this article was obtained from Zacks.com Options tables sourced from yahoofinance.com.
Disclaimer: 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.