Last week, I explained the nuts and bolts of covered call investing - a bullish strategy that focuses more on returns than it does on risk.

In my column, I used the example of Yamana Gold (NYSE: AUY), showing you how to reduce your cost when buying stocks - and thereby increasing your upside potential if the shares move higher.

Today, we’re going to kick things up a notch and explain how you can cleverly take the same covered call strategy and add a twist, by using deep-in-the-money covered calls. When you do so, you can achieve more consistent returns over time, while also protecting your capital.

Simply put, I’m going to focus on mitigating risk…

Getting Deep-In-The-Money… Even When Your Stocks Fall

With a conventional covered call strategy, you buy regular shares of a stock and then sell a call option against them, whose strike price is higher than the current share price. Your aim is that the shares will move higher and will get called away at expiration for a profit.

While this does happen, it doesn’t occur as often as you might think. Plus, it usually only happens during an upward moving market.

However, with the deep-in-the-money (DITM) covered call strategy I’m focusing on today, we’re not expecting the shares to move higher. In fact, we don’t even need the stock to trade higher in order for us to make money. It can actually go lower (sometimes much lower) and we’ll still make money.

Pretty compelling, right?

In short, what we’re seeking is safety. And to get it, we need to employ a strategy that protects us much more often than not.

Deep-In-The-Money Calls: A 75% Win Rate Over 13 Years

So how about a win/loss ratio of 75%? That’s the performance the deep-in-the-money strategy recorded over the past 13 years that I’ve used it. That means we’ve only lost money or broken even 2.5 times out of 10. At all other times, we’ve made money, usually notching up market-beating returns.

Just yesterday, in fact, in my Strategic Income service, we closed out two winning positions - 13% on Wells Fargo (NYSE: WFC) and 33% on Goldcorp (NYSE: GG) - positions we initiated before the market’s collapse.

Here’s how it works, using the Yamana Gold example again. Recall that in last week’s example, we bought Yamana under $9 and sold the $10 (out-of-the-money) calls against our position.

Using Deep-In-The-Money Covered Calls On Yamana

This time, we’re going to buy the same Yamana shares. But instead of selling the $10 calls, we go deep-in-the-money instead.

• Buy 1,000 shares of Yamana at $9.50 - a total outlay of $9,500.

• Sell 10 contracts of the January 2010 $9 calls (AUY-AL). Trading at $1.75 per contract, you receive proceeds of $1,750 (remember that each contract contains 100 shares, so it’s $1.75 multiplied by 100 = $175. Then $175 multiplied by 10 = $1,750).

• Your cost for Yamana shares is now $7.75 ($9.50 minus $1.75) - a full 18% below the current price. This is the crucial number. If Yamana closes above $7.75, you’ll be profitable.

• If Yamana closes above $9 at expiration, you’ll make 16%. You arrive at this number in this way…$9 (strike price) minus $7.75 (cost) = $1.25 (profit).
  $1.25 divided by $7.75 = 16%.

  If the stock moves higher, your returns are capped at 16%, regardless of where it goes.

• Even if Yamana shares stay at today’s level, you’ll still make 16%. So you have an additional chance of profiting from the trade, versus just one with a straight long strategy, which requires the shares to move higher.

Additionally, you reduce your cost of ownership in Yamana to $7.75.

Basically, you’re saying that you’re willing to own Yamana at $7.75 - 18% below current prices. But if you don’t get the shares at that price, then you want to be paid for trying - something that happens nearly 80% of the time.

Key Points to Remember When Using DITM Covered Calls

Here are a few things to remember whenever using deep-in-the-money covered calls:

• You can execute a deep-in-the-money covered call strategy in any trading account.
• If you do end up with the shares, you can sell additional calls against your position to reduce your cost even further. The goal is to own the shares for zero dollars or even a negative cost over time.
• Always make sure you employ position sizing - i.e. never put too much in a single investment.
• At expiration, if the shares are trading above your strike price, they’ll be automatically taken from your account.

That’s all for this issue.

Karim Rahemtulla

Disclosure: No positions

Beware of dodgy headlines. Beware of soft estimates.

As earnings season forges onward, nervous investors are latching onto any morsel of good news they can find - even if it’s artificial.

Take Caterpillar (NYSE: CAT), for example. With a history dating back to 1925, the company is now the top manufacturer of construction, mining, and forestry equipment, plus industrial turbines and engines for machinery and power generation systems. Whether it’s construction, agriculture, energy, marine, or infrastructure, Caterpillar’s presence is splashed across several sectors.

It’s no surprise, therefore, that its quarterly numbers are always keenly anticipated and thoroughly scrutinized - not just because it’s one of America’s leading firms, but because it’s also a key indicator of economic health.

And its latest batch of results don’t bode well…

Caterpillar’s Second Quarter Crawl

Back in April, my colleague Karim Rahemtulla noted the importance of Caterpillar’s performance as a barometer for the wider economy.

It came as the company reported its first quarterly earnings loss since 1992, as profits sank by $112 million on a 22% drop in sales.

And the second quarter proved to be a struggle, too…

• Revenue: Plunged by 41% to a shade under $8 billion, led by a 43% drop in equipment and 32% fall in engine sales. It was the third straight month of equipment sales declines. By region, machinery sales tanked by 51% in North America… 61% in Europe… 47% in Latin America… and 25% in Asia-Pacific. Large equipment sales are Caterpillar’s biggest revenue generator.

• Profit: Got whacked by 66% - $371 million (60 cents per share), compared with $1.1 billion ($1.74 per share) in Q2 2008. This was due to falling demand for its products in the midst of a recession, but also from less obvious factors like lower commodities prices (and consequently profits) at some of Caterpillar’s key mining customers.

To see results like this, you’d think the company’s shares would be getting walloped. They’re not. The stock ended today up $2.81 (7.9%). And this month overall, the stock is up 17.9%.

And this highlights another key point: Earnings season is nuts.

Bring Out The Arbitrary Analysts And Fickle Investors

Remember that “artificial” good news I mentioned earlier?

With companies terrified of missing their earnings forecasts and seeing a subsequent stock drop, estimates are generally conservative. Very conservative.

With Caterpillar, for example, the average estimate from Thomson Reuters and Bloomberg analysts was 22 cents per share. The company actually earned 60 cents. Similarly, Caterpillar projects its full-year earnings to slide into a chasm-like range between $1.15 and $2.25 per share. Again, this blows away the $1.01 per share analyst estimates.

Do yourself a favor. Don’t pay any attention to analyst estimates at the moment - they don’t mean diddly. And take earnings reports for what they are - temporary catalysts that often don’t reflect the real story.

In April, Caterpillar CEO Jim Owens cited a “high degree of uncertainty” about the global economy, continuing, “It’s extremely difficult to know how our customers will respond during the remainder of 2009.”

If he doesn’t know, do you really think that analysts have a better idea? Or the investors who merrily pile on after the company beats arbitrary estimates?

Some of Caterpillar’s gains came courtesy of heavy cost-cutting measures (the company has shed 17,100 full-time workers since December and a further 17,000 contract and temporary workers), lower production, and a lower tax rate.

There is a bright side…

The “CAT Scan” Of The Global Economy

Even as the recession squashes demand for its products and a “great deal of economic uncertainty” exists, Caterpillar was able to raise its full-year earnings forecast from $1.15 per share to that range between $1.15 and $2.25.

As Owens states, this was due to “signs of stabilization that we hope will set the foundation for an eventual recovery.” He continued by saying that, “Credit markets have improved significantly. Fiscal policy and monetary stimulus have been introduced around the world, and we are seeing signs, particularly in China, that they are beginning to work.” Owens is complimentary of China’s massive infrastructure spending plan.

An improved global outlook is crucial for Caterpillar, given that about two-thirds of its sales came from outside the U.S. in 2008, according to Bloomberg.

At the moment, however, Caterpillar says the global economy could fall by more than 2% this year, compared with the 1.3% drop it forecast in April. And its predictions aren’t random. Bloomberg says Caterpillar correctly forecasted the U.S. economic recession in October 2007 - two months before it officially began.

The company says the U.S. economy was still in recession at the end of the second quarter and anticipates another decline in the current three-month period before growth picks up towards the end of the year.

This supports the view that while the recession is easing, it’s not yet over. For example, the National Association for Business Economics’ just-released quarterly survey says…

• Companies reporting earnings losses outnumbered those with higher profits for the sixth straight quarter.
• More than two-thirds of the companies said they laid off workers during the second quarter, compared with a measly 6% that added jobs - the lowest in the survey’s 30-year history.
• And Reuters quotes the survey: “Industry demand was still declining in the second quarter of 2009, but the breadth of decline had narrowed considerably since late 2008, raising prospects for stabilization in the second half of the year.”

Time will tell. Just be sure you get the full story beyond the headlines, the analysts’ estimates, and short-lived earnings reports in the meantime.

Best regards,
Martin Denholm

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Disclosure: No positions

Dear Smart Profits Report Reader,

I want to expand on my colleague Martin Denholm’s excellent piece yesterday about the spin on Caterpillar’s (NYSE: CAT) earnings.

As Martin mentioned, don’t take a company’s quarterly results at face value. Earnings and guidance are very conservative this year, so it shouldn’t come as a shock when a company beats its projections. Just because a company like Caterpillar crushes its estimates, it doesn’t mean the business is humming along. It just means they beat the estimate.

That said, at a time like this, it’s important to figure out why the earnings come in better than expected. Were sales higher than forecast? Did margins improve? Was it due to a lower tax rate? Lower general and administrative costs (layoffs)?

Yahoo! (Or Not)

On Tuesday, Yahoo! (Nasdaq: YHOO) doubled up on analysts’ estimates, notching earnings per share of 16 cents, versus expectations of 8 cents. That was on a non-GAAP (Generally Accepted Accounting Practices) basis, though. Using GAAP, the company earned 10 cents per share - a penny more than in the same period last year.

Behind the flashy headline numbers, Yahoo actually experienced a 13% decline in sales. It offset that with a $120 million decrease in sales and marketing expenses and $50 million less in general and administrative expenses (most likely due to layoffs).

Starbucks Brews Up Earnings… But Are They Real?

Despite a revenue decline of 6.6% during its fiscal third quarter, as all-important same store sales dropped by 5%, Starbucks (Nasdaq: SBUX) was still able to post a profit of $151 million or 20 cents per share. That beat EPS estimates by a penny and compared to a loss of $6.7 million during the same period a year ago.

To its credit, management was able to shave operating costs at company-owned stores from 42.1% of revenue to 41.9%. But the big change to this quarter’s income statement was the roughly $175 million in cost-saving, mainly by closing stores.

It took $51.6 million in restructuring charges this quarter, versus $167.7 million a year ago.

Starbucks also had an additional $33 million benefit, due to lower interest expenses, higher interest income, plus other items when compared to last year.

But even though the company swung to profitability, a quick comparison of this quarter’s numbers versus the same data from a year earlier shows that the real story behind the profitability was because of savings from closed stores.

Still, that’s not necessarily a bad thing. Starbucks did need to cut back ( as long as they dont cut the one by my office). And if the company can show increased profitability from existing (and any new) stores in the future, then its cost-cutting moves will prove fruitful.

Right now, though, a look at Starbucks’ numbers tells us that its recovery is still early in its development. Too early, in my opinion, to make for an attractive investment.

Delta Air Lines: A Tale Of Lower Revenues And Poor Traders

Here’s another example of how the mainstream media can mislead.

Some outlets reported that Delta Air Lines’ (NYSE: DAL) revenue shot up by 27%. But some journalists didn’t take the company’s acquisition of Northwest into account. Their combined revenue actually fell by 23%.

In addition, while Delta did report better than expected numbers, losing 24 cents per share, 5 cents better than consensus estimates, it would have turned a profit if not for losses suffered when trying to hedge fuel costs.

So in Delta’s case, the airline was actually operating in the black, despite lower revenues. That was until some traders got involved and bet the wrong way on fuel prices.

I don’t love the airline business, but if Delta can show me another quarter where it manages its business efficiently, it could be an interesting recovery play. Assuming some oil traders don’t mess things up, of course.

Clearly, this is just a quick look at these companies’ earnings reports. But even then, it reveals more information than the headline numbers you see reported in the press. Unless you drill into those numbers, they can be pretty much meaningless.

Hoping your longs go up and your shorts go down.

Marc Lichtenfeld

Disclosure: No positions

Last week, the market did what it often does best: Confounded the experts and did the opposite of what most people expected.

This time, the market teased technical traders, luring them into thinking that the Dow and S&P 500 were mapping out a bearish “head-and-shoulders” pattern in the wake of the indexes topping out in mid June.

As the news gathered momentum on blogs and in newsletters, mainstream media outlets like CNBC and Bloomberg began running with the story. And that was part of the problem!

It soon became clear that this particular pattern might not follow the conventional path - a theory that gained credibility when both the Nasdaq 100 and Nasdaq Composite traded at new recovery highs when the closing bell sounded last Friday.

So what is going on here?

This Pattern Signaled A Reversal… Or Did It?

Below is a daily chart of the Dow Industrials, which I published in the weekly “Inside Mt. Vernon Research” e-mail last Friday. (This publication is only available to subscribers of Mt. Vernon’s Research paid products).

As you can see, there is a clearly defined “head-and-shoulders” pattern spanning the last two months. However, what many people forgot is that while this pattern usually signals a reversal, it also has a failure rate of around 30% - something I also I warned my 1-2-3 Trader subscribers about.