A Power Play on American Electric Power

by John Kmiecik | September 13, 2012 9:05 am

Now that summer is almost over, it’s fun to look back and reflect on some things that happened. The market as a whole was generally slow, with less-than-average trading volume. The economies of the U.S., Europe and China — not to mention others — were talked about frequently regarding both debt crises and growth.

Now that we’re approaching fall, these issues are still to be resolved. Besides discussing world economies, it was just plain hot and dry in the U.S. So, here’s a covered call trade idea on a company that was able to take advantage of the hot weather and still has more upside potential.

The theory on this covered call trade example is this:

American Electric Power (NYSE:AEP[1]) ranks among the largest generators of electricity, owning 38,000 megawatts of generating capacity in the U.S. Some analysts have upgraded the stock recently, including Jefferies. It raised its target price to $47.50 based on a 2015 EPS estimate of $3.45. The price-to-earnings ratio average for the industry is just below 17, and AEP’s is about 10.5, which is an advantage compared to its peers.

If you need to feel good about a company you’re investing in then AEP has you covered. For the sixth year in a row, AEP was honored as an adoption-friendly workplace.

Technically, the stock has been slowly and methodically moving higher since mid-May. The next area of resistance may be in the $48 area, which kept the stock from heading higher late in 2007.

AEP $43.50

Example: Buy 100 shares of AEP @ $43.50 and sell the October 44 call @ 40 cents

Cost of the stock: 100 x $43.50 = $4,350 debit

Premium received: 100 x 40 cents = $40 credit

Maximum profit: $90; that’s $50 ($44$43.50 x 100) from the stock and $40 from the premium received if AEP finishes at or above $44 @ October expiration.

Breakeven: If AEP finishes at $43.10 ($43.50 40 cents) @ October expiration.

Maximum loss: $4,310, which occurs in the unlikely event that AEP goes to $0 @ October expiration.

Trade Management

The objective on 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 $44. If the stock moves up the maximum amount without being called away, gains are enjoyed on the shares and the option premium. Then the process can be duplicated for the next expiration if so desired.

AEP hasn’t shown many volatile moves in the past, but a trader must be aware. If it rises faster than anticipated and past the $44 strike, an adjustment be implemented. 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 will give the position a chance to increase its return if the stock moves higher.

If the stock drops in price more than anticipated, 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 had no positions in any security mentioned here.

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

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