Employing out-of-the-money short-term covered calls can help you generate additional income. Based on my analysis I have elected to employ this strategy on some of our 3M and Hershey's shares.
In previous articles I have indicated that I fall in the camp of investors of the opinion that a general market pullback is becoming increasingly probable. While other investors of the same opinion might suggest trimming certain positions or exiting positions outright, I shy away from selling. I would much rather invest in great companies, monitor their performance and business outlook, and almost never sell any of my holdings.
Given that I almost never sell, I know it is inevitable that I will own shares of companies when they appear to be fully valued or excessively valued. In the case where I think there is a reasonable probability that a company’s share price will pullback, or an increase in the stock price is likely to be muted in the short-term, I will write an out-of-the-money covered call.
When I enter such a position, my intent is not to reap an astronomical return from such a trade. I am merely endeavoring to augment the dividend income generated from the underlying security with option premiums received from other investors willing to pay for the option to acquire my shares at a predetermined value before a predetermined expiry date.
For the most part, the stock price of the companies in which I have invested are not highly volatile. As a result, the option premiums for short-term out-of-the-money covered calls might look unappealing to some readers. To date, however, I have been able to generate a few hundred dollars, or a few thousand dollars, on each option trade and I still own the underlying shares; Becton Dickinson (BDX) is an exception but I ‘lucked out’ and in my recent Korn Ferry and Becton Dickinson – Covered Calls article I explain how I ‘lucked out’.
Other out-of-the-money covered call articles can be found by accessing my archived articles.
In today’s article I bring to your attention the short-term out-of-the-money covered calls I initiated March 26th on 3M Company (MMM) and The Hershey Company (HSY). This is the first time I have initiated covered call on MMM but in this article I disclosed that I had written short-term out-of-the-money covered calls on HSY; those options expired worthless and I still own the underlying shares.
Here are the details of today’s option trades.
On January 29, 2019, MMM released Q4 and FY2018 results.
While MMM generated GAAP EPS of $8.89 vs. $7.93 in FY2017, it is important to back out certain non-recurring items (ie. a net charge of $1.57/share related to the Tax Cut and Jobs Act, a Q1 2018 legal settlement, and a $0.50/share net benefit from divestiture gain). Backing these out and MMM generated Adjusted EPS of $10.46 vs. $9.17 in FY2017.
In the Q4 Press Release, management revised its FY2019 earnings to $10.45 - $10.90/share versus a prior expectation of $10.60 - $11.05/share.
If we use the revised adjusted earnings range and the current ~$207 share price we get a forward adjusted PE ratio range of ~19 - ~19.81.
The projected diluted PE and adjusted diluted PE levels are rich for my liking but I think it is entirely possible that irrational Mr. Market will bid up MMM’s share price. I have, therefore, written several covered calls contracts (each contract equals 100 shares) to expire May 17, 2019 with a $220 strike price; this provides me with a ~$13.00 stock price increase buffer. In exchange for writing these covered calls, I have received $1.51/share.
The Hershey Company
On February 4, 2019, HSY released Q4 and FY2018 results and provided FY2019 guidance.
On February 20, 2019, HSY’s President and CEO presented at the 2019 Consumer Analyst Group of New York (CAGNY) conference. During the presentation, it was reaffirmed that HSY’s FY2019 reported net sales are expected to increase in the 1% - 3% range, full-year reported diluted EPS are expected to increase 3% - 6% and full-year adjusted diluted EPS are expected to increase 5% - 7%. This growth is driven by operating profit margin gains as well as a more favorable tax rate. Due to the timing of investments throughout the year as well as the gating of the sales growth, management expects EPS growth to be stronger in the 2nd half of the year.
If we increase FY2018 diluted EPS of $5.58 by 3% - 6% we get a projected range of ~$5.75 - ~$5.91. With HSY currently trading at ~$113 we get a projected diluted PE range of ~19.12 - ~19.65.
If we increase FY2018 adjusted diluted EPS of $5.36 by 5% - 7% we get a projected range of ~$5.63 - ~$5.74. With HSY currently trading at ~$113 we get a projected adjusted diluted PE range of ~19.69 - ~20.07.
The projected diluted PE and adjusted diluted PE levels are rich for my liking but I think it is entirely possible that irrational Mr. Market will bid up HSY’s share price. I have, therefore, written several May 17, 2019 covered calls with a $120 strike price (a ~$7/share buffer). In exchange, I have received $1.13/share.
I have absolutely no idea what will happen to MMM’s and HSY’s respective share price in the short-term. I do, however, think valuations are currently stretched based on earnings guidance. In my opinion, the probability of each company’s share price reaching the strike price prior to expiry is low and I am hoping the options expire worthless.
As we get closer to the May 17, 2019 expiry I will provide an update on the status of these two trades.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long MMM and HSY.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.