Subscribers to "Income From Covered Option Writing" got an early look at this material.
In man's journey to dominate the solar system via technology, the spear followed soon after the early hammerstones, scrapers and bone or stone knives. This adoption of a simple lever extended our reach and may represent the birth of engineering. Like Paleolithic man, our use of engineering in the financial markets offers us vastly improved lifestyle opportunities.
Today, I'll structure an arbitrage to Engineer Income for CMI using dividends and covered option writing across a narrow time window. For a more detailed understanding and explanation of what Engineered Income is, see the opening article of this on-going series.
Briefly stated, E.I. is an arbitrage using a dividend capture and a covered option premium to generate income in investment cycles of two to six weeks. This enables the synthesis of dividend driven income 8 to 24 cycles per annum instead of just the usual 4 quarterly dividends typical for income investors. Furthermore, the absolute cash income is approximately 1X to 2X the size of the dividend payment of the ticker being arbitraged. That is to say that Engineered Income using tickers with quarterly dividends of $1 is structured to generate $1 to $2 of cash income 8 to 24 times per year instead of the $1 quarterly. Clearly, this magnification of cash flow is large. Because of the nature of the arbitrage construction, market risk is actually reduced during the short duration holding period of a few days to 6 weeks.
Phillips 66 (NYSE:PSX)
Current Market Price: $76.15
Next ex-Dividend for $0.63 announced for 8/16/16.
Engineered Income Opportunity: Buy-Write using the calls for 9/16/16 $72.50 @ $4.50 premium. Net Debit: $71.65. Net premium: $0.85.
WARNING: The arbitrage must be entered so as to have your purchased shares of record before the ex-dividend close of market. Most brokers require five business days, making the deadline to initiate the trade 8/8/16. If in doubt, check with your broker for your latest available buy date to capture the dividend.
The catalyst for this opportunity is built into the structure of the engineered trade, which is an arbitrage between the option premium and dividend over a short time range.
6 contracts: $42,990.00 cash investment for our target sized investment.
6 X 100 X $0.85 net premium = $510.00 net premium income.
Call Strike is $3.65 in the money, likely to be called by expiration in 44 days. Also likely to be called away before the 8/16/16 ex-dividend date (just 13 days).
Result of early call before ex-dividend is to earn $510 on the $42,990 investment. This is an absolute gain of 1.19% for less than 13 days invested. The short term allows for 24 investing cycles per annum, calculating to a 28.47% adjusted annual net total return (before compounding).
Result of call at expiration adds the $0.63 dividend to the $0.85 net premium for a total gain of $1.48. $1.48 X 6 X 100 = $888.00 absolute gain, 2.07%. The 44-day holding period would allow eight investing cycles per annum for a 16.52% adjusted annual net total return (before compounding).
Downside risk occurs if a call-away does not occur at all. In such even, our breakeven point is the original market buy of $76.15 less $5.13 (the combined $4.50 premium + $0.63 premium) = $71.02. This is 6.7% below current market and would likely have to occur in the next 13 days or else a call-away for the option owner to capture the pending dividend is more likely and would end any downside exposure in the investment.
The company reported 2nd quarter earnings and had its earnings call the past week. This effectively eliminates most potential surprises for the potential 44-day investment window. A potential major project or asset physical failure is unlikely but always possible, either natural or terror-induced.
Engineering has assured us of at least $0.85 income, exceeding the $0.63 dividend itself. Capture of both premium and dividend is possible and rated as a moderate, likely probable outcome.
The highly accelerated investment cycles of 8 to 24 periods, instead of just 4 per annum, generates Alpha through engineering. This is a low risk arbitrage between the dividend and option premium, built across a difference in Market price and strike price set against premium and a narrow time frame.
The engineered returns of 16% to 28% adjusted annual net total return compares to a four years (total history available for the company) average annual net total return for PSX of 23.07% and for the S&P 500 as represented by the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) of 12.61%.
Score about a tie for Engineered Income for this period, thanks to the outstanding performance of PSX generating its own market Alpha for the period.
This is part 2 in an ongoing public series of Engineered Income arbitrage opportunities. All investors should keep in mind that some options trade thinly and may not be suitable for this technique. Small traders (generating under $250 net premium income per trade) may find a significant portion of their returns eaten away by transaction costs even if using a discount broker.
Additionally, be advised that the basic due diligence as to suitability of the investment and quality of the company, including fundamental value analysis, momentum, technical support levels and liquidity need to be carefully considered for each opportunity. If you are not prepared to do all this foundational work, then I caution you to pass by this strategy or use a service to help gather and present the information for you to begin from.
If you find this article thought-provoking, please consider becoming a follower by scrolling back to the top and clicking the <FOLLOW> link next to my name. This ensures you get a notice of all my work as it is published and gives me feedback to know what readers find of interest. You will find a full index to all published Engineered Income articles HERE in my blog. Thanks for taking the time to read. Join the comments section below to continue this discussion and share your thoughts and experience.
Disclaimer: I am not a licensed securities dealer or advisor. The views here are solely my own and should not be considered or used for investment advice. As always, individuals should determine the suitability for their own situation and perform their own due diligence before making any investment.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PSX over the next 72 hours.
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.
Additional disclosure: I am also long SPY