A Shorter-Term Play on Utilities

by John Kmiecik | June 14, 2012 8:31 am

They might be boring compared to more volatile stocks, but if they are slowly climbing, they also might make excellent covered call candidates. Here is a potential stock that is doing just that.

The theory on this covered call trade example is this:

Duke Energy (NYSE:DUK[1]) is one of the largest electric utility providers in the United States, and it also runs hydroelectric generators in Latin America. DUK has a current dividend yield of 4.3% with a payout ratio of close to 90%. Many analysts forecast annualized EPS growth of 4.2% over the next five years, which makes the stock a nice potential long-term candidate.

For the past five months, DUK has traded in a range of $20 to $22. At the beginning of June, the stock was able to break out over $22 and climb just above $23. Considering that the stock might be a little extended, and current market conditions being what they are, DUK could drift down to the $22 area before once again trying to head higher.

DUK: $22.85

Example: Buy 100 shares of DUK @ $22.85 and sell the July 23 call @ 30 cents
Cost of the stock: 100 X 22.85 = $2,285 debit
Premium received: 100 X .30 = $30 credit
Maximum profit: $45 — that’s $15 (23 – 22.85 X 100) from the stock and $30 from the premium received if DUK finishes at or above $23 @ July expiration.
Breakeven: If DUK finishes at $22.55 (22.85 – .30) @ July expiration.
Maximum loss: $2,255, which occurs in the unlikely event that DUK goes to $0 @ July expiration.

Trade Management

The main objective for a covered call strategy is for the stock to just rise up to the sold call’s strike price at expiration, which in this case is $23. The stock moves up the maximum amount without being called away, gains are enjoyed on the shares and the sold call expires worthless.

Considering the past performance of the stock, it is highly unlikely that DUK will move much higher than the sold strike before July expiration. In the event it does, the call option can be bought back and a higher strike can be sold against the position to avoid assignment. This will allow the stock to remain in the portfolio and also give the position a chance to increase its return.

If the stock drops in price more than was anticipated or much below $22, it might make sense to close out the entire trade (stock and short call) to possibly avoid further losses.

As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities.

Endnotes:
  1. DUK: http://studio-5.financialcontent.com/investplace/quote?Symbol=DUK

Source URL: http://investorplace.com/2012/06/a-shorter-term-play-on-utilities-duk-covered-call/
Short URL: http://invstplc.com/1nRcaai