Covered Call Strategy with American Oriental BioEngineering

Includes: AOBI, MDLZ
by: Jason Tillberg

Over the weekend, I went to a 19th Century Village Restoration on Long Island showcasing homes and businesses from Long Island during 19th Century. The Village had all the characters in uniform acting as the very people who lived or worked in the homes or businesses back then. The hat maker, working in his little shop with his wood burning stove actually made a good living. He made his hats and would sell them in Manhattan for cash to a wholesaler. He saved his money and bought a 600 acre farm according to the bearded man playing the role of the hat maker. His 600 acre farm was his retirement fund. He could rent it out, mortgage it off for monthly income or hire labor and farm the land for profit. It was good old 19th Century financial planning.

What about today? What are some ideas for passive income to retire on or simply earn an income from? Lets assume you have $250,000 to invest. What can you get from $250,00 today for monthly income?

Passive Income

Yields today are rather paltry and I don't know about where you live, but where I live, the cost of most things I buy are going up: Sugar, Gas, Tolls, Stamps, Eggs all up. Inflation in stuff I buy is going up more than the rates above. I need to do better!

Management of my risk is very important. If I want to speculate, I'll go to the Belmont Stakes on June 6th with the $250,000 and let it ride on the favorite to Show. But of course, I won't.

I have an idea that I think warrants some of my investment funds that I believe provides a good risk reward.

It begins with shares of a stock I wrote about in March, American Oriental Bioengineering (AOB). I recommended it at 3.98 a share suggesting it was in the bargain bin based on valuation.

Shares of AOB are currently 4.56 per share. With the whole $250,000, I could buy about 55,000 shares today.

The January 2010 5.00 call is being bid for 1.00. I could sell 550 of the January 2010 5.00 call for $55,000 in premium. That would reduce my cost basis by 1.00 to 3.56 not including any transaction costs. The option expires in less than 8 months and the yield of the premium based on the cost of the investment is 22% ($55,000/$250,000). This substantial yield over the less risky investment offers the reward that I believe compensates the risk.

I tell myself, if I can make 10% a year, I'm doing terrific. For me to make 10% per year on my $250,000, I need $25,000 in income or $2,083 per month. Because the premium received is $55,000 over 8 months, taking $25,000 over 12 months provides a considerable cushion as I'm provided with more than enough premium. If AOB is below 5.00 per share come the 3rd Friday of January 2010, I could sell the June 2010 5.00 calls again for more option premium. If AOB goes above 5.00, I would lose my shares at 5.00 making an additional 44 cents per share or $24,200 in capital gain. My total maximum profit would be $79,200 ($55,000 in option premium + $24,200 capital gain = $79,200). That would be a gross return of almost 32% in 8 months.

From the chart above, I'm not going to get $25,000 per year on any of the choices I have. The most I will earn from passive income would be $11,500 from a dividend on a stock such as Kraft Foods (KFT) which is yielding 4.6% currently. Kraft has a lot of debt and given the recent rise in the 10 year treasury yield, if the cost of that debt becomes too high to service, Kraft may have some significant problems down the road.

AOB I believe offers a decent risk reward for a long term investment and also offers considerable income for utilizing the strategy of buying shares and selling longer term out of the money covered calls.

Disclosure: Long AOB for myself and my clients