The Core Portfolio Options Play

by Lawrence Meyers | February 12, 2013 9:30 am

Thanks to the Fed gorging itself on every bond that comes to market, bond prices have gone up while yields have all but vanished. This has placed many fixed-income investors in a real pickle. How can they pick up some badly needed income yet not expose themselves to too much equity risk? (After all, that was the beauty of bonds: low risk, nice yield!)

One alternative is a strategy using covered calls with great, world-class companies. This involves choosing a company with no chance of going under, buying the underlying stock, then selling covered calls against it. The key is to choose a stock you wouldn’t mind owning anyway (in the event you get stuck with it). The premiums you’ll pick up aren’t huge, but over a year, you’ll beat that 3%-4% you were getting in a bond.

Mostly, these are stalwarts that historically do not have gigantic moves up or down, except in the case of some extraordinary event. You only expect 8% to 10% annual returns on these stocks anyway, so why not sell some calls against them? If you get stopped out, you just buy back in. After all, these are stocks that would make for a fine addition to your core portfolio anyway. If the stock gets called away, then repeat this strategy.

Ideally, the stock actually does get called away right around the strike price, so you pocket the premium and are able to buy the underlying again and sell another call. There’s no need to be greedy here. Grab a 1% to 1.25% return monthly, and you only need to do it four or five times a year to replace that bond income, and still yield even more if you want to keep rolling it over.

I like using energy producers because oil’s volatility gives an energy producer like ConocoPhillips (NYSE:COP[1]) enough volatility to yield a nice premium. It’s currently trading at $57.59 as of this writing. The COP March 57.50 Calls are selling for 78 cents. That’s a 1.36% return for a month (or 16% annualized).

Another solid play is Abbott Laboratories (NYSE:ABT[2]) — just the kind of company that’s survived through thick and thin. Today’s price is $34.26, so you have a couple of choices here. The March $34 Call is at 80 cents, so you’ll net out 54 cents for a 1.6% return. Or you could sell the March $35 Call for 32 cents. In that case, you’d pocket at least the premium for a 0.95% return, but an additional 2.2% return if the stock is called away.

You can buy PepsiCo (NYSE:PEP[3]) today at $72.36, then turn around and sell the March $72.50 Calls for 78 cents. That’s a 1.1% return, and a 1.3% total return if its called away.

As of this writing, Lawrence Meyers[4] did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc.[5], which  brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses. He also has written two books[6] and blogs about public policy, journalistic integrity, popular culture, and world affairs[7]. Contact him at pdlcapital66@gmail.com[8] and follow his tweets @ichabodscranium.

Endnotes:
  1. COP: http://studio-5.financialcontent.com/investplace/quote?Symbol=COP
  2. ABT: http://studio-5.financialcontent.com/investplace/quote?Symbol=ABT
  3. PEP: http://studio-5.financialcontent.com/investplace/quote?Symbol=PEP
  4. Lawrence Meyers: mailto:pdlcapital66@gmail.com
  5. PDL Capital, Inc.: http://www.pdlcapital.com/
  6. written two books: http://www.investorplace.com/author/lawrence-meyers/
  7. blogs about public policy, journalistic integrity, popular culture, and world affairs: http://www.breitbart.com
  8. pdlcapital66@gmail.com: mailto:pdlcapital66@gmail.com

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