From now on some of my articles will be published exclusively at Seeking Alpha. I wrote an article called Two Short Ideas for Bearish Investors, which was published there yesterday.

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Before looking at the results, note that there was nothing particularly clever about the selection of stocks (the 12 largest stocks in the U.S. by market capitalization at the time the first article was written) or the timing (I suggested selling calls after a significant increase in the market and selling puts after a significant decrease). The following chart shows that I was not nailing any tops or bottoms.

The table below shows strike prices of the options sold and the premiums received as well as the underlying stock prices at the time of option sales and currently:

Half of the stocks would neither be put nor called, leaving the investor in the same position as in a passive strategy, except for the joy of pocketing the option premiums. The shares that exceeded the call strike prices at expiration and therefore being sold were WMT, AAPL, GOOG, IBM, and PG. Only BAC shares ended lower than the put strike price and would therefore leave the investor with a double dose of that troubled bank. The portfolio can obviously be rebalanced at any time.

Disclosure: Author is long MSFT, AAPL, JNJ, BAC, T.

* Current dividend yield over 4%.

* Growth rate of dividends over 3% in the last five years.

* Low or medium fair value uncertainty (as determined by Morningstar’s analysts).

I eliminated from the list healthcare companies (since I wrote about them recently), financials (due to lack of transparency and risks that are not easily quantified) and limited partnerships (due to tax issues that can complicate the picture). That does not mean that I think companies in these categories are ill suited for income investing – only that I wanted to avoid them in this article for the sake of simplicity. Perhaps I will address them later in a separate article. The list of candidates was further trimmed down to what I subjectively consider the best opportunities.

The surviors are two telecoms, AT&T (T) and Verizon (VZ); two consumer goods companies, Kimberly-Clark (KMB) and Pitney Bowes (PBI); and three utilities, Exelon (EXC), PPL Corporation (PPL), and Entergy (ETR).

All of these stocks could have a place in the portfolio of investors looking for income with relatively low risk. Like before, the idea is to get a good return on modest or even no share price appreciation, while being willing to take the risk of the shares moving down strongly. This involves buying shares and selling strangles as described in Part 1.

Judging by options prices,  all the stocks are perceived to have roughly equal risk. Implied volatilities for at-the-money options expiring in January 2012 range from 22% to 28%. PBI and PPL do not have traded options further out than July of 2011. Exelon is highlighted here as an interesting trade.

 Exelon Corporation (EXC)

Exelon, whose 11 nuclear plants in the Midwest and Mid-Atlantic generate 17% of U.S. nuclear power and nearly 4% of all U.S. electricity consumed, is the largest nuclear plant operator in the United States. The company has endured a difficult operating environment in the last couple of years due to weak demand for power and the share price has suffered as a result. Looking ahead, however, the company and its investors should benefit from its strong position as a low-cost producer of electricity with minimal greenhouse gas emissions.

Analysts are on average forecasting just about flat revenue and earnings in 2011 as compared with 2010.

The main reasons this trade would go wrong is if either power prices start falling again or regulatory changes bring on price caps.

 Suggested Options Trade

The example assumes that 100 shares are purchased and a put and a call option are sold. For the put option I use the $40 strike price and for the call the $45 strike.

The static return – which assumes no change in the share price – on this trade is $670, which is a 17.8% return on the initial cash outlay or 8.4% taking into account cash to secure the put options sold.

If the share price is above 45 on expiration the shares will be called away, leaving the investor with no position. A 6.6% increase in the share price would give the investor a 25.2% return on the initial cash outlay or a 11.9% return assuming the puts are cash secured.

For this trade to produce a loss, the share price would have the be under 37.77 at expiration, a 10.6% decrease from current prices and a price level only briefly touched in recent years.

 Waiting for better timing, and getting paid for it

Many, myself included, are of the opinion that the stock market in general is overextended and due for a pullback. Therefore, now might not seem like the best time to be adding to stock market exposure. One way to approach a trade like the one described above is to establish the initial stock position by selling puts on a monthly basis and selling the strangle later.

For instance, in the case of EXC February puts with a strike of 42 can now be sold for a dollar per share. If you were to sell these puts, five and a half weeks from now you would either find yourself with EXC shares with a cost basis of $41 per share (2.9% under current prices) or you would have collected a dollar per share in premium. If you had the shares put to you, you would then most likely be in a position to collect a higher premium for selling the strangle.

Dislcosure: Author is long EXC and T.

Considering historical growth of revenues and earnings, as well as estimates for the coming years, all of those companies appear reasonably valued. Hewlett-Packard (HPQ) has a strikingly low forward P/E ratio and Apple (AAPL) has a lower one than might be expected for a company experiencing breakneck growth and with a massive amount of cash. Of the companies on this list, only Intel (INTC) and Microsoft (MSFT) provide meaningful dividend income.

The idea is to profit handsomely on modest or even no share price appreciation, while being willing to take the risk of the shares moving down strongly. This involves buying shares and selling strangles as described in Part 1.

Judging by options prices all the stocks are perceived to have roughly equal risk, with implied volatilities for at-the-money options expiring in January 2012 in the mid to high 20s. Apple is the exception, with implied volatilities in the low 30s. Here I will use Microsoft as an example.

Microsoft Corporation (MSFT)

The company so many people love to hate, Microsoft nevertheless grows revenues and earnings year after year. Over the last five years, annual revenue growth has been 9.4% while earnings have grown 13.4% per year. In the current fiscal year (ending June 2011) analysts expect revenues to grow 9.8% and EPS to grow 16.7%, on average.

The big risk Microsoft faces is that cloud computing will cut into the profits of its two big cash cows, Windows and Office. While this is certainly a valid concern, it will take many years to play out and it should not be forgotten that Microsoft is and is likely to remain one of the key players in cloud computing.

Suggested Options Trade

The example assumes that 100 shares are purchased and a put and a call option are sold. For the put option I use the $27.5 strike price and for the call the $32.5 strike.

The static return – which assumes no change in the share price – on this trade is $474, which is a 19.8% return on the initial cash outlay, or 8.5% taking into account cash to secure the put options sold.

If the share price is above 32.5 on expiration the shares will be called away, leaving the investor with no position. A 15.8% increase in the share price would give the investor a 38.3% return on the initial cash outlay or a 16.5% return assuming the puts are cash secured.

For this trade to produce a loss, the share price would have the be under 25.42 at expiration, a 9.5% decrease from current prices.

Dislcosure: Author is long AAPL, CSCO, and INTC

Trading a Range with Covered Short Strangles

One strategy for generating significant income from high-quality stocks is to invest in a portfolio of them while simultaneously selling both put and call options against the shares. Income is received through dividends as well as option premiums. As I think of this strategy, a trading range is being committed to: The investor is content to add to his position if the price of the stock falls and to sell the shares if they rise a certain amount, say 10-15%. Selling both puts on calls on the same stock is known as being short a strangle (or a straddle if the strike prices are the same – I personally prefer the strangles), and the strangle is covered when the underlying shares are also owned.

Healthcare Bargains

For my first batch of trading ideas, I am concentrating on healthcare stocks. My list is split between major drug manufacturers and makers of medical equipment. These companies have all experienced positive revenue and earnings growth in the last three years and are generally considered low-risk. They are also all companies I would be comfortable holding fairly large positions in, which for me is key when selling put options – I am willing to have them exercised and increasing the position if the stock price drops.

All of the stocks above make sense for a trade like the one I have described and having a portfolio of these trades makes for a good income-producing strategy. Following is an example of a potential trade:

Abbott Laboratories (ABT)

This diversified health-care company derives about 60% of revenues from pharmaceuticals and the remainder from various nutritional health-care products and medical devices. The company has shown remarkably consistent revenue growth in the last decade. On average, both revenues and earnings per share have grown 8.9% per year in the last ten years. The table below shows key numbers from the last five years as well as estimates for 2010 and 2011.

Earnings growth is expected to continue, with analysts on average forecasting 4.17 dollars per share in 2010 and 4.66 dollars per share in 2011, which translates into a forward P/E of 10.3. Abbott Laboratories currently has a 3.7% dividend yield and has raised its dividend each year for the last 37 years.

Suggested Options Trade

As an example, I will show my ABT trade. It consists of owning ABT shares as well as being short Jan 2012 puts with a 47.5 strike and short Jan 2012 calls with the 52.5 strike.

This trade would return 20% on the initial cash outlay without any change in ABT shares and the shares will have to fall almost 10% in the next 13 months to produce a loss. A payoff graph, excluding dividend payments, looks like this:

Dislcosure: Author is long ABT and JNJ

Is the growth story over?

Here is how the valuation looks at the moment: Apple has $51 billion in cash and marketable securities, which comes to around $55 per share. Subtracting that from the share price ($308.43 at the time of writing) leaves us with roughly $253 per share. Apple had earnings of $15.15 per share in the last twelve months, giving us an ex. Cash P/E ratio of 16.7. That would be considered normal for a company with decent, but unremarkable, growth potential. Potential explanations for this valuation are concerns about Steve Jobs’ health as well as increasing competition against the iPhone coming from Android and elsewhere. I consider the concerns valid, but they must be weighed against the upside potential Apple still has.

First, an overview of Apple’s performance in the last ten years:

In the words of Morningstar’s Apple analyst: “…Apple has weathered the current economic downturn relatively well…”, an amusingly understated interpretation of the company’s performance in the last few years.

Whereas some see the reliance on the US consumer as a negative for Apple, a look at Apple’s revenue composition and breakdown of growth would lead me to a different conclusion: there is still tremendous opportunity in foreign markets. As the table shows, growth in America, while still rapid, is tame in comparison to the explosive growth elsewhere. Apple is ramping up its store openings in China in anticipation of further growth there.

Here is a breakdown of revenue. The iPhone is the big seller, but Macs keep gaining market share. With each successful product launch, the allure of using Apple’s operating system increases.

My Apple options strategy

There is nothing wrong with simply buying Apple shares – clearly I expect the shares to appreciate in coming years. I am using a different approach, however. As I think there is limited risk to the downside and significant upside potential (but probably nothing like what we’ve seen in the last 10 years), I am willing to use options to gain some leverage. My approach is a so-called diagonal call, in essence a covered call writing strategy, where instead of owning the shares, I own long-term call options. I am long the January 2012, 320 strike option and short the Jan 2011, 340 strike. At current prices you could expect to pay around $43 per share for the long-term option and to receive $4.3 per share for selling the shorter-term option at 340.

On dips I’m planning to either sell out of the money puts (if options premiums are high) or buy calls expiring in 2013 (if premiums are low). In addition to increased leverage, this strategy allows for more flexibility than simply buying and holding and if well executed can generate significant income. The key is not to get too greedy by selling calls at strikes too close to the share price. If you share my bullish opinion on the shares, you will want to be sure to gain handsomely on strong upwards moves.

Disclosure: Author is long AAPL.

Usually a press release from the Fed is considered sufficient to explain its actions. But following the Fed’s announcement on Wednesday of the widely anticipated QE2, the second round of quantitative easing — a massive plan to buy government bonds — Bernanke wrote an article in the Washington Post. After patting the Fed on the back for its “strong and creative measures to help stabilize the financial system and the economy,” Bernanke goes on to explain the thinking behind QE2. 

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

The Bernanke put, formerly known as the Greenspan put, could hardly be more clearly stated: In reaction to economic weakness, The Federal Reserve will actively try to inflate asset prices and given the tools at its disposal, it will be able to do so in nominal terms.

How did this go last time?

What is not mentioned anywhere by the chairman is the downside to following this strategy. Low returns on cash and bonds will have investors placing riskier bets. This may seem benign at first as markets rise, but eventually it leads to more volatile markets and poor use of capital. The boom and bust cycles from the tech mania of the late 1990s and more recently in housing should have made this clear enough.

It is hard to say exactly what the effects on asset prices will be this time around and how long it will be until these actions spawn the next financial crisis, but it is my guess that the cycles are getting shorter and more extreme.

The rise of the U.S. stock market in recent months is in large part due to a weakening dollar and the increase in stock prices pales in comparison to the increase in commodity prices. Does Bernanke really believe this policy will increase consumer demand without leading to inflation? And what is to keep this new money from leaving the U.S. in search of better opportunities elsewhere? Finance ministers from a number of Asian countries have already voiced their concerns. These concerns were dismissed by Tim Geithner, who doesn’t seem to think that massive amounts of hot money rushing into economies and later rushing out even faster is a serious problem.

But more notable are Geithner’s inconsistencies when it comes to his opinions on the dollar. On one hand he thinks the current level of the dollar results in a huge current account deficit so he would like other currencies to gain strength against the dollar. On the other hand he claims to support a strong dollar policy and says that “We will never use our currency as a tool to gain competitive advantage.” And how does this fit in with president Obama’s stated goal of doubling exports in five years, which is nothing but a call for a weaker dollar? Leaving aside these contradictions, it seems strange that Geithner is telling people what will be done with the U.S. dollar as he has little control over it. No wonder that Geithner’s remarks are routinely met with a mixture of annoyance, indifference and laughter around the world.

U.S. economic policy, both fiscal and monetary, is currently incoherent. But the order of the day seems to be to stimulate in the near term and worry about the consequences later. We will know we are in real trouble when Paul Krugman’s (pictured with cat) insatiable appetite for stimulative measures will be met.

Investment implications

For those who still own some government bonds, I would recommend selling them as their yields are far too low to compensate investors for the risk of owning them. Luckily, there is a buyer in the market who doesn’t care too much about risk and return – The Federal Reserve.

Earlier, I have advocated selling both put and call options to enhance portfolio returns. In light of the recent drop in implied volatilities in the options market coupled with the uncertainties brought on by the actions of the Fed, I think purchases of both longer term (expiring in January 2012 and later) puts and calls are worth considering. For puts I would favor the U.S. stock market (using SPY as a proxy) and for calls emerging markets (VWO or EEM, for instance) as well as high-quality domestic stocks with good upside potential (AAPL comes to mind).

Disclosure: Long SPY puts and AAPL calls.

There is now a new crop of tech favorites. Many of them are expected to profit from the rise of “cloud” computing, and no doubt some of them will. But the lesson from a decade ago is that the big winners are hard to spot ahead of time and if they are all priced for perfection, the safest bet is probably to stay away from them altogether, or perhaps even take positions against them.

Some tech stocks fall somewhere in between, priced for some growth, but given their track records the valuations can hardly be called excessive. Apple and Google are the most notable companies in this category, both of which look reasonably priced considering their rapid growth and pristine balance sheets.

Disclosure: Long INTC and AAPL. Short AMZN, VMW, CRM, and RHT.