I periodically employ a conservative 'out-of-the-money covered call' option strategy when I think I can generate some option premium income and I have a strong probability of retaining the underlying security.
In recent articles (here and here) I disclosed that I occasionally write short-term out-of-the-money covered calls if I think there is a strong probability the price of the underlying shares will remain below the strike price until the option expires.
For the sake of full disclosure I now provide this very brief article in which I disclose that I have written 2 $365 July 17, 2020 covered call contracts on Canadian Pacific Railway Limited (CP). Prior to nominal commission, this trade has generated $3.725/share or $745 for the 2 option contracts; the underlying shares are held in an account for which I disclose details.
In March I disclosed in this article that I had acquired CP shares at an average cost of $278.615. The share price has subsequently appreciated to ~$341.
Looking at CP's Q1 2020 results we see $2.98 in YTD diluted EPS. In addition, CP 'now expects volume, as measured in revenue ton miles, to be down mid-single digits and adjusted diluted EPS to be roughly flat year over year'.
Let's be generous and assume CP generates $3.05/quarter/share over the next 3 quarters. Add in the $2.98 in diluted EPS for Q1 and we get $12.13 in estimated diluted EPS for FY2020.
With shares trading at ~$341 we get a forward diluted PE of ~28.1. If CP's share price appreciates to the $365 option strike price we get a ~30.01 PE. Both levels strike me as somewhat rich. Furthermore, if the Canadian and US economies continue to experience short-term headwinds, I think CP's earnings will come under pressure and I expect CP's share price to pullback from current levels come the July 17 contract expiry date.
One could argue that, given my outlook, I would be wise to sell the underlying CP shares and reap a ~$62/share pre-tax profit. I, however, rarely sell shares and have no intent of parting with my CP shares. In fact, my plan is to increase my CP exposure when the valuation becomes more reasonable.
Although I fully expect the covered call contracts to expire worthless thus resulting in the retention of the:
- option premium I have collected;
- underlying shares;
it is possible that CP's share price could surge above the $365 strike price. Should this occur, I will need to determine whether I want to close out my position and write new covered calls at a higher strike price further out on the calendar or whether I am prepared to let my shares be called away.
I like the North American Class 1 railroads because there are few participants and the barriers to entry are so high.
The following is the list of Class 1 railroads; I have highlighted those in which I have exposure.
- Union Pacific Railroad (UNP)
- Canadian National Railway (CNR)
- CSX Transportation (CSX)
- Norfolk Southern Railway (NSC)
- Canadian Pacific Railway (CP)
- Kansas City Southern Railway (KSU)
Note: BNSF Railway (fka Burlington Northern Sante Fe Railway) is the second largest Class I railroad after UNP but was taken private in 2010 and is now part of Berkshire Hathaway Inc. (BRK-a) (BRK-b).
I have elected to write short-term out-of-the-money covered calls on my underlying CP shares because I think they are currently overvalued and I do not want to sell them. By following this conservative option strategy, I am skimming additional income with the expectation that I will be able to retain the underlying shares.
Stay safe. Stay focused.
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 CP.
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.