I made a variety of options trades this week, even as the market firmed up and volatility declined. I initiated two new short options positions – I sold covered calls against a core long position in an energy pipeline company and naked puts against another oil driller (see details below).
I also closed out several short put option positions, and adjusted another. The put options I bought back were simply too tempting to ignore, having very cooperatively begun shedding premium almost immediately after I first sold them. The adjusted position was to reduce risk in a naked put option position on a medical equipment maker whose stock took a huge hit on bad earnings news.
Closed/Adjusted positions:
Altria Group (MO: 22.91 +0.53%, yld: 6.06%) – Given MO’s recent run-up, on 7/22/10 I opportunistically bought to close (for $0.22) the December 17-strike naked put options I sold against MO on 6/14/10 for $0.66, for a 6-week net return of about 2.2%. *
Beckman Coulter (BEC: 46.50 +1.86%, yld: 1.58%) – On 7/23/10, in a risk reduction move, I rolled out and down the November 55-strike put options I was short against BEC as the underlying shares were slammed after the company reported disappointing second-quarter earnings and lowered their full-year outlook. I bought back the original put options (which I’d originally sold at $3.20) for $9.35 and sold an equal number of February 50-strike puts at $6.85, for a small overall net credit.
While these earning results were not good, barring longer-term fundamental issues the shares in this maker of medical diagnostic equipment appear reasonably valued at $50 or below. In the broader context, the healthcare sector as a whole has been under-performing the rest of the market and probably remains – along with perhaps oil drillers – the most undervalued industry sector.
iShares High Yield Corporate Bond ETF (HYG: 87.86 +0.30%, yld: 8.80%) – HYG has also moved up nicely since I sold a December 80-strike put option against it (for $5.10) when my existing limit order triggered during the “flash crash” on 5/6/10. I decided to opportunistically take profits in this position given how much the premium on the options had come in, and on 7/20/10 my limit order to buy back the put options triggered at $1.55, closing out the position for a 2-1/2 month net return of over 4%. *
Vodaphone Group (VOD: 24.84 +2.01%, yld: 5.17%) – VOD has performed well since I sold some October 17.5-strike put options against it for $1.05 on 5/14/10 and the options had since lost almost all of their premium, so on 7/22/10 I took profits by buying the options back (at $0.10) to close out the position for a 2-1/2 month net return of over 5%. *
New positions:
Ensco plc (ESV: 42.87 +0.19%, yld: 1.75%) – On 7/22/10 I sold some March 30-strike puts against ESV for $1.75 as the stock dipped during some intraday weakness:
Based in London, Ensco plc is an offshore contract drilling company that provides both shallow and – more recently – deepwater drilling services to the oil and gas industry worldwide. Risks to earnings include lower energy prices, competition (from the likes of Transocean, Diamond Offshore, Noble and Rowan Companies) and general operating risk, while positives include its newer-than-average fleet of rigs, high operating margins, its expansion/diversification into deepwater drilling, and operations mainly in the Asia/Pacific region with only minor deepwater exposure in the Gulf of Mexico.
Trading at almost $42 and yielding 3.4%, shares of ESV appear to be in an intermediate-term uptrend, but have been severely buffeted in recent months – along with other stocks in the sector – from the news coming from the Gulf of Mexico. A break below the $39 level might suggest a retest of the recent lows in the mid to low $30s.
Valuation wise, current fair value estimates for ESV range from the low $40s to over $100, with an average fair value estimate somewhere in the $50s – clearly suggesting that the stock could be undervalued here. An additional plus is the dividend: the company recently announced a major increase in its quarterly dividend, from a measly $0.025 to $0.35 per share, giving the shares a meaningful yield.
If I stay short the put options until expiration and they expire out of the money (OTM), my net return will be 5.6% in 8 months, or about 8.4% annualized. If ultimately put the stock, my net cost basis will be about $28.33 per share with a corresponding dividend yield of almost 5%.
Enterprise Products Partners L.P. (EPD: 38.45 +1.00%, yld: 5.93%) – On 7/22/10 I sold some March 39-strike covered call options for $1.50 against part of my long position in EPD (initially established two years ago after being assigned some EPD put options that I’d sold, and later increased after the company acquired TEPPCO Partners, which I was also long from a put option assignment) as the units extended a strong rally into new all-time-high territory:
Based in Houston, Texas, Enterprise Products Partners is the largest publicly traded master limited partnership (MLP). It provides a range of midstream services – including processing, storage, transportation, and terminalling – to producers and consumers of natural gas and natural gas liquids in North America.
Risks to earnings and unit price include some commodity exposure and potential for reduced transportation volume demand, changes in tax legislation that could reduce the tax-advantaged status of MLPs, potential unit dilution through secondary sales, and rising interest rates (which can increase costs for MLPs and the appeal of alternative investments). Positives include the company’s size, diversification and financial wherewithal, as well as its stable fee-based operations and history of increasing distributions.
Trading at almost $39 and yielding just under 6%, units of EPD are clearly in an extremely strong short- and intermediate-term uptrend that’s not likely to be called into question unless they break back below the $36-$37 level. At the same time, the units are “overbought” on an intermediate- and longer-term basis and exhibiting some negative divergences, suggesting that the potential for a top of some sort forming in the coming weeks/months can’t be overlooked.
Fundamentally, EPD currently appears roughly fairly valued to perhaps slightly overvalued based on its price to distributable cash flow and expected earnings/cash flow growth going forward. Based on the traditional spread of about 2% between average MLP distributions and 10-year bond yields (currently about 3%), there appears room for the yield on EPD to come down further (and for the unit price to rise) as long as interest rates remain low.
I consider EPD a core holding in my portfolio and am not looking to exit my complete position. However the unit price run-up has resulted in the position exceeding the usual 2-3% maximum size that I allocate for any position in my portfolio, so prudence suggests taking some action here. If I hold the covered calls until expiration and they expire OTM I’ll have generated an extra 3.7% return and reduced my cost basis in the position; if the units are ultimately called away, I’ll have reduced my position size in EPD back down to normal levels and locked in a sizable profit (about 38% plus distributions) on the rest.
* As always, the return on sales of cash secured or naked put options was calculated based on the premium received from the sale of the options (minus commissions) against the unmargined capital set aside to pay for their possible assignment (i.e., my being put the shares of the stock).
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