Investing for Income in 2011 with Stocks and Options – Part 1

Generating a decent rate of return on an investment portfolio, while not taking too much risk, is challenging in a low interest rate environment. The standard safe investment — longer term Treasury bonds – currently offers a low rate of return with plenty of risk as demonstrated by recent market action. High-quality stocks, some with dividends yielding more than the bonds, generally seem to offer much better value.

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.

  2005 2006 2007 2008 2009 2010 2011
Revenue    22,338    22,476    25,914    29,528    30,765    35,120    38,210
EPS 2.17 1.12 2.34 3.16 3.71 4.17 4.66
Free cash flow      3,967      3,991      3,528      6,056      6,186    
Dividends per share 1.09 1.16 1.27 1.41 1.56 1.72 1.76

 

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

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4 Responses to Investing for Income in 2011 with Stocks and Options – Part 1

  1. Matt Powell says:

    Very interesting. Do you know of and recommend any funds or etfs that are dedicated to this approach?

  2. Here is an article about covered-call ETFs — a similar concept even if puts are not used. I am not familiar enough with any of them to give recommendations.

    http://seekingalpha.com/article/37478-an-in-depth-look-at-the-new-covered-call-etfs

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