The strategy we are going to look at today has two components to it. In the first part, we sell a put. In the second part, the proceeds from the sale of the put are used to leverage your position in Duke Energy (NYSE:DUK). It is best to use this strategy on stocks that have pulled back and are trading in the oversold ranges, but your general long-term outlook for the stock is still bullish. Duke Energy satisfies all three conditions. The long-term trend is still strong. The stock has pulled back from its highs, and it is currently trading in the oversold ranges.
The benefits of this strategy are twofold. If the stock should take off while you are waiting for the shares to be assigned to your account, the calls you purchased will protect you from missing out on any gains. On the other hand, if the stock pulls back, you have the chance to get in at a price of your choosing.
The Technical Outlook
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The stock has pulled back nicely after trading to a series of a new 53-week highs from June-July of this year. The stock has also moved nicely from the overbought ranges to the oversold ranges, and is now trying to put in a bottom. It has a strong amount of support in the $62-$63.00 ranges, and there is a good chance it could trade down to these levels before trending higher. If it traded down to these levels and then reversed course, it would put in a nice double bottom formation. Stocks usually tend to trend higher after a double bottom is in place. We would wait for a test of at least $63 before putting this strategy into play. Consider placing a stop at $57.50. If the stock trades below this level, it would indicate that a test of its two-year lows at $50.60 was more likely than a move to the $68-$70 ranges. On the other hand, if it closes above $65.50 on a weekly basis, it will be a strong indication that the stock is ready to at least trade to the $70 ranges, and possibly challenge its recent highs.
Charts Of Value
The blue shaded area represents the dividends. The orange line represents the valuation growth rate line. Generally, when the stock is trading below this line and in the shaded green area, it represents a good long-term entry point. The last time this occurred was in the last week of November in 2011. The stock is currently trading roughly on this line, and it is oversold. Hence, the current setup makes for a good long-term entry point. According to F.A.S.T. Graphs, it has an estimated earnings growth rate of 4.5%.
When a stock is trading above the EPS and EPS consensus estimate line, it is in a bullish phase, and the outlook is for higher prices. In this case, the stock is trading well above the EPS line, so the stock should continue to trend higher, and strong pullbacks can be viewed as buying opportunities.
A look At The Competition
Several key ratios will be used to compare Duke Energy against its competitors and the industry in general. We will be looking at American Power (NYSE:AEP), CenterPoint Energy (NYSE:CNP) and Southern Company (NYSE:SO). The strategy described in this article could also be applied to these companies if your outlook on them is bullish. Net income and revenue is listed in billions. For example, revenue for Southern Energy is $16.9 billion.
Wait for Duke Energy's stock to pull back to the $62.50-$63.00 ranges before selling any puts. The April 19, 2013 60 puts are trading in the $1.40-$1.50 ranges. If the stock pulls back to the stated ranges, these options should trade in the $1.90-$2.10 ranges. We will assume that the puts can be sold at $2.00 or better. For each contract sold, $200 will be deposited into your account. We are using rough estimates to gauge the price of the option. The trade should be based on the stock pulling back to the $62.50-$63.00 ranges. At that point, the options could even trade higher, or perhaps slightly lower.
The April 2013, 67.50 calls are trading in the $0.70-$0.85 ranges. If the stock pulls back to the stated ranges, these calls should trade roughly in the $0.35.-$0.55 ranges. We will assume that these calls can be purchased at $0.45 or better. You could purchase up to four calls for each put sold and still have a net credit of $20.00.
Benefits And Risks Associated With This Strategy
As an investor, you have an opportunity to significantly leverage your position in this stock for a relatively low fee. You would only need to put up $6000 to secure the put, but you would be in a position to control up to 400 shares. If you purchase fewer calls, the amount you have to put up will drop. For example, if you purchase only one call, then you would have to put up $5845. You would have a left-over balance of $155 from the puts you sold after purchasing one call.
You have the opportunity to get into this stock at a lower price. 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 $58.45 (if you purchased one call only) to $59.80 (if you purchased four calls).
As long as you are bullish on the stock, having the shares assigned to your account should not be an issue. If you do happen to change your mind and feel that the stock could trade well below the strike price you sold the puts at, you can simply roll the put. Buy back the old puts and sell new out of the money puts.
Duke Energy stock has pulled back nicely and is now trading in the oversold ranges. The long-term trend is still strong, and the stock has given the first signs that it is putting in a bottom formation. The ideal set-up would be to retest its recent lows before trending higher. If it were to test its recent lows, it would put in a nice bullish double bottom formation. A weekly close above $65.50 would signal higher prices were in the works. It could potentially trade past $70.00 before pulling back.
Our suggestion is to close at least half the position out if it is showing gains in the 60%-100% ranges. You can seek higher returns once you have taken some money off the table.
Options tables sourced from Yahoo Finance. Option Profit loss graph sourced from Poweropt.com. Competitor comparison data sourced from Yahoo Finance. EPS consensus charts sourced from Zacks.com.
Disclaimer: It is imperative that you do your due diligence and then determine if the above strategy meets your risk tolerance levels. The Latin maxim caveat emptor applies -- "let the buyer beware."