An Energy Policy

Includes: CAT, CHK, HAL, RIG, WLT
by: George Acs

My policy is simple. Don't let energy go to waste.

Whereas every bouncing ball dissipates energy with each and every bounce, sooner or later the energy is fully depleted and that ball needs to be recharged. Stocks are a completely different matter, though. There is energy stored in each and every stock that actually has a viable product or service and isn't just a momentary "flash in the pan."

The energy comes from price movements as shares inevitably go up and down. Of course, you could junk your grandfather's buy and hold strategy and become a day trader, trying to capitalize on every minute movement until your lose it all, or you could take a hybrid approach and let the rubber band snap over and over again until its time and energy are up, and then snap it or any one of the other rubber bands again.

This is what energy looks like:

(click images to enlarge)

In the case of Transocean (NYSE:RIG), the pent up energy is stored in each move up and released on the way down. But the energy just keeps renewing itself and opening up many opportunities.

I write incessantly about the value of a covered call strategy. It can get pretty annoying pretty fast, but I've been reasonably obsessed with it as a strategy for about five years

I will readily admit that there have been some periods of time when the market has gone straight upward, without any meaningful rest, when the strategy hadn't matched the market. Of course, that assumes that the proponent of buy and hold actually decided to sell at some point and convert paper profits into real ones. It also, to some degree, assumes that the holder of stocks was in possession of perfect timing and always sold stocks at their peak pricing.

What I especially like about covered option strategies is that, to a large degree, it can atone for an individual's poor stock selection and poor timing, just like life insurance can help atone for poor health habits.

The only difference is that you don't have to die to get something positive, even out of your mistakes.

As an added bonus, the sale of options creates an immediate stream of income that can be put to work, perhaps by purchasing additional shares.

During a typical market cycle, when stocks do alternate between ups and downs, there are many opportunities to purchase shares and repurchase them, often at or below the original strike price, at some point after they have inevitably been assigned.

Just as a reminder, every time you buy a stock and sell a call or sell a cash covered put, you receive a premium for a nameless and faceless individual who very likely is attempting to leverage his assets and make a quick profit, based upon some intuitive sense that there will be a meaningful movement in share price within a specified period of time.

It's nice to have that kind of certainty and confidence. I don't, at least not in my own divining abilities. But I am confident enough to take their money in the knowledge that many times, the money received is a better return for the specified period of time than the shares themselves could have offered, as they are continually subject to daily micro- and macro-economic factors that tug in all directions.

Obviously, it's easy to cherry pick when presenting "case studies." I tend to trade in and out of a defined universe of stocks, adding a few new ones each year, while also discarding some. The ones that I discard are the losers, and they aren't likely to ever regain my confidence. I'm also not terribly likely to write about them, unless I'm in need of catharsis or income tax losses.

For purposes of presenting "cases," I focus on the initial holding term to either the closing date of the last position held, or October 12, 2012 in the case of currently open positions. For the buy and hold universe, I simply look at the price at the beginning of the period to the price at the end. However, I also look at the potential return if someone did have perfect timing and sold shares at their peak price during the holding period.

Of course, that gets compared to the returns derived from capital gains or losses on underlying shares, and the accumulated premiums from selling calls or puts, and the accumulated dividends during their period of holding.

Let's begin with Chesapeake Energy (NYSE:CHK). In this case, my timing was not so good, since initial shares were obtained as a result of having sold puts and then being assigned shares. In an ideal world, when I sell puts I would prefer that they end up expiring rather than being assigned to me. Although I wouldn't recommend selling puts in companies that you do not want to own, that's different from expressing a preference. Once you own it, you have to manage the energy stored within -- and Chesapeake has lots of energy.

Beginning with a put sale on June 18, 2012 and going through to October 12, 2012, the ROI on shares of Chesapeake Energy would have been 13.1%, including dividends, at a time when the S&P 500 would have returned 8.9%. As expected, the perfect timer would have sold shares on August 9, 2012 and realized a 12.9% return.

Through the wild bouncing and discharge of energy, and most of all, its capture, serial call sales on shares of Chesapeake Energy and repurchase of assigned shares at times when prices reflected dissipation of energy, by contrast resulted in a 44.9% return.

The returns from similar series of transactions with Transocean and Halliburton (NYSE:HAL) weren't quite as exhilarating as with Chesapeake, but they were also illustrative of the theme. Finally, an energy policy that makes sense.

If your tastes, however, run a bit more to the wild side, and you get easily bored with the likes of Chesapeake Energy, Transocean and Halliburton, there's always Walter Energy (NYSE:WLT).

Purchased on July 30, 2012, it reached a recent peak price of $38.24 on September 14, 2012. That would have represented a 12.4% realized return, as compared to a 4.4% paper gain for those continuing to hold shares at Friday's closing bell. By contrast, the covered option sellers not only have a 17.6% return to date, but nearly 50% of the total gain has already been realized and put to work elsewhere.

These days when listening to pundits, there's always talk of derivative plays. Since my focus, for want of developing a theme, has been on energy, perhaps a quick look at a product needing energy to run might be in order.

Caterpillar (NYSE:CAT) is a stock that was recently caught up in "The Cummins Massacre" for the second time in 90 days. I currently hold two lots of shares, and present holdings from an initial purchase date of July 2, 2012 until October 12, 2012.

During that period, Caterpillar shares were initially purchased at $85.02. At Friday's close, they were selling for $82.79. Add in a dividend payment in July and for good sake, another upcoming this week, and the return for the buy and hold investor is -1.4%

Of course, if you had perfect timing, you could have sold your shares on September 14, 2012 at $93.66 -- or a 10.8% return -- including a single dividend payment.

Compare that to the 17.8% derived from selling calls and the occasional put. True, a bit more frenetic than simply buying and holding or finding that perfect exit point, but no one says that the process has to be pretty.

All of a sudden, playing with a bouncy, bouncy ball doesn't seem so juvenile.

Disclosure: I am long CAT, HAL, RIG, WLT, CHK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.