Southern Company (NYSE:SO) is a great long term holding for almost any portfolio. It is one of the largest and best managed utility companies in the United States. Its rate of return 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 it has consecutively increased its dividend for 11 years in a row.
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. This is where the bull put spread comes into play. It provides you with the chance to get into this stock at a great price or the opportunity to earn up to 21% in just four months without taking on too much risk. You simultaneously sell one out of the money put and purchase one put that is farther out of the money for a net credit. The long put (the one you purchased) serves as a hedge just in case things do not go as planned. Your total risk is equivalent to the spread between the two strike prices. This would only occur if the stock closed at or below the lower strike price. The maximum gain is achieved if the price of the stock trades at or above the highest strike price.
Benefits of a Bull Put Spread
- It limits your losses if the stock suddenly plunges. Your loss is limited to the total differences between the strike prices of your short put (the put you sold) and long put (the put you purchased).
- The ability to profit even if the stock barely budges in price.
- The risk is significantly lower than writing a naked put as your maximum downside is limited by the put option you purchased. For example, if you sold a put on Merck & Co. Inc. (NYSE:MRK) with a strike at 45, and the stock dropped to zero, your loss would be $4500 minus the premium you received. Now if you purchased a put with a strike at $40.00, your maximum loss would be $500 minus the net premium you received. The difference is rather significant.
- The capital requirements are considerably less. With cash secured put you would need to have enough cash in your account to back the sale of the put. If you sold a put with a strike at $45, you would need to have $4500 in the account. With the bull put spread, your capital requirement is limited to the spread between the two strike prices. In the above example, the spread is $500. This is significantly less than the $4500 you would have to put up if you sold a cash secured put on Merck with a strike at 65. This strategy should not be abused just because the capital requirements are significantly less. This is a conservative strategy, and by abusing it, you will have converted into a speculative strategy.
- In the event the stock declines, an investor can buy to close the short put position and continue to lock in gains from the long put as the price of the underlying stock drops.
The stock completed a double top formation on the 27th of July and shortly after that it broke down. It then put in an initial bottom the 14th of September, but such strong corrections usually do not end suddenly. There is a good chance that the lows will be tested before the stock has a chance to trade to new highs. The stock tends to pull back almost every time it tests the +2 standard deviation Bollinger bands (indicated by the yellow boxes in the above chart). It just touched these bands and almost immediately started to pull back. Thus, there is a good reason to believe that the stock will test the $44.50-$45.00 ranges before trending higher. Consider waiting at least for the stock to test the $45 ranges before putting this strategy to use.
Southern Company will be rated against its peers using several key metrics such as P/E, quarterly revenue growth, operating margins, PEG, etc. This will give you further insight into the company. If you find one of its competitors to be a better play, you could implement a similar strategy.
M= Million B= Billion
Charts of Interest
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. Based on this relationship, the stock is currently slightly overvalued. The suggested strategy could help you get into the stock at a price that is pretty close to the valuation growth rate line. Fastgraphs has an estimated earnings growth rate of 5.60% for Southern Company.
The stock is in a strong uptrend and trading well above the consensus EPS line. Historically, stocks tend to perform better when they are trading above this line. In the case of Southern Company, the long-term outlook looks pretty good as the stock is trading well above this line.
Bull Put Spread
The Feb 2013, 44 put is trading in the $0.83-$0.87 ranges. If the stock pulls back to the $44.50-$45.00 ranges the put should trade in the $1.20-$$1.30 ranges. We will assume that the put can be sold at $1.20 or better.
The Feb 2013, 40 puts are trading in the $0.20-$0.23 ranges. If the stock pulls back to the stated ranges the put should trade in the $0.40-$0.50 ranges. We will assume that this put can be purchased at $0.50 or better.
- After the sale and purchase of the respective puts you will have a net credit of $70.00.
- Your maximum risk is $330 (the spread of $400 between the two strikes subtracted from the credit of $70).
- Your maximum profit is $70 per spread for a possible return of 21%.
- Your breakeven point is $43.50.
Risks associated with this strategy
The main risk is that you over leverage yourself because the capital requirements are so small. Using the example in this article, you would need $4500 to sell one cash secured put in Merck. However, you would only need $500 to write one bull put spread. This means you could technically write up to 9 bull put spreads. There is always the chance that the shares could be assigned to your account if the stock is trading below the strike price of the option you sold. Thus, the biggest risk is that an investor might abuse this strategy. If the shares are put to your account, you could always turn around and sell them, provided you had the funds in place to cover the initial purchase.
The net credit you get from the trade is usually much smaller than the maximum amount of money you could lose from the trade. Thus, it would be wise to close the short option out or roll the option before your position hits the maximum loss point. You roll the option by buying back the put you sold and selling a new out of the money put. Your breakeven point with Southern Company is $43.50.
Do not abuse this strategy as there is always a chance that the shares could be assigned to your account. The hedge you have in place via the long put does not prevent this from taking place. If the shares are put to your account, and you don't have the money in place to purchase them, you could be in serious trouble. This is a conservative strategy, and if you abuse it, you will have converted it from a conservative strategy to a speculative one.
Options tables and competitors data sourced from yahoofinance.com. Option profit loss tables 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was prepared for Tactical Investor by one of our analysts. We have not received any compensation for expressing the recommendations in this article. We have no business relationships with any of the companies mentioned in this article.