It has been a great few months for bulls, especially for those who had bought early in the rally, and for late arrivals who took advantage of the November dip. However, knowing when to take money off the table is never easy, particularly when momentum is working strongly in your favor. One way to take advantage of strong bullish momentum is to sell covered calls on your existing holdings.
What is a covered call?
A covered call is an option transaction where the seller of the call, who also owns shares, creates a contract which offers the buyer, the right to purchase the shares at a fixed price, within a given time frame. The seller earns a premium from the sale. If at the time of expiration of the contract, the share price is higher than the contract price, then the contract is exercised and the shares are sold at the agreed price ('strike price'). If at expiration the share price is less than the strike price, the contract expires worthless and the seller of the call keeps the shares.
The benefit of the covered call is it allows the shareholder to earn money by selling options. The disadvantage, is if the share price heads south quickly, well then it may be necessary to buy back the option contract before selling the shares, compounding the loss. Therefore, the best candidates for covered calls are stocks which are in long standing uptrends, selling an option contract at a strike price above the current price. This earns the seller the premium from the contract sales, plus any capital gain from the sale of the stock at the strike price if the option is exercised. Ideally, you like to keep the premium and the shares so you can repeat the process!
Covered call candidates
A number of stocks have made strong gains since I have featured them, and thus are ideal candidates for this strategy. , , and have all achieved gains over 50% since featured.
Tesoro Corporation (NYSE:TSO) Corporation emerged from a 4-month base after clearing $46. Opinion suggests there may be more upside to follow. Lower costs for oil refining, driven by developments in shale oil and gas, have reversed a rough period for the industry since the start of the recession. In Tesoro's case, the increase in crude oil production from Canadian oil sands has provided a much needed boost to the U.S. refinery sector. While domestic demand for refined products is expected to decline in the long term, demand from Latin America is expected to grow; this will greatly benefit Tesoro Corporation over the coming decade. Latin America consumed 8.5 million barrels/day of refined product in 2011, but should reach 10 million before 2020. At this time, domestic consumption is expected to be unchanged at around 16 million barrels/day, which is below the mid-noughties peak of 18 million barrels/day. Increased global exports could add another 10% by 2020.
Tesoro's P/E of 11.6 is below the Industry average of 15.3; another marker flavoring higher prices. At time of writing, a $50 May 2013 option call traded at $3.40 (when the stock closed at $48.69). To buy the underlying, and sell the call could net a potential 9.7% return over the 3.5 months, assuming the stock didn't drop below the buy price.
Krispy Kreme Doughnuts (NYSE:KKD) price doubled since the mid-November swing low. When featured back in September it carried a P/E of 3.3, but this has pushed to 5.7 following the huge price advance. However, the key reason for the low P/E is an income tax expense credit which added $135.9 million to net income. Removing the tax credit from income gives an adjusted P/E of 27.7. This adjusted P/E is still well below direct competitor Dunkin Brands Group Inc (NASDAQ:DNKN)'s 81.3, and is comparable to Starbucks Corporation (NASDAQ:SBUX)'s 30.2. So while the price advance is incredible, the stock is not necessarily expensive. Revenue was up 8.5% last quarter, with an impressive 6.8% increase in same store sales. The company continues its aggressive international expansion as it opens its first franchise spot in India, in addition to a partnership plan with Citymax Hotels for 80 more retail spots (to be built over 5 years). There was also a new franchise development for Singapore. Where the risks lie is increased raw material costs, but given deflationary pressures on commodity prices these should be manageable.