Shares of energy producer Encana (NYSE: ECA) have been moving steadily higher since January. In fact, while the S&P 500 Index is only up about 2% for the year, ECA investors have enjoyed a gain of 18% on their stock position. And this doesn't even include the $0.07 dividend the company paid to investors of record on March 12.
Selling puts for income is a good way to participate in a stock that has established a strong bullish trend, while avoiding the risk of purchasing at the peak of that trend. By selling puts against the stock, we commit to buying shares if the stock pulls back below the strike price of our put option contracts.
Conversely, if the stock continues to rally, we may not fully participate in the profits that a shareholder would receive -- but we would be able to generate a healthy amount of income from the puts that we sell against the stock.
Today, I want to set up such a trade by selling puts against Encana, a natural gas and oil producer with operations in the United States and Canada.
The company has focused on natural gas production, but management is adjusting course to accelerate the high-return liquids businesses. Rather than increase production across the board, management has committed to adding only high-quality wells to the company's portfolio, which in turn should help to create more profit stability despite volatility in energy markets.
Looking forward, there is a significant amount of uncertainty regarding energy prices. Oil has moved back above $100 a barrel in recent months, and a few analysts are making headlines calling for $150 oil, with the possibility for prices to exceed $200 if political tensions spiral out of control.
Meanwhile, natural gas has been volatile over the past quarter, spiking as cold weather sets in, and then settling back to levels that are still well above normal compared with the previous two years. (My colleague David Sterman recently offered his forecast for natural gas stocks.) While volatility remains high, it appears that the multi-year bear market for natural gas has finally come to an end, with prices trending higher since bottoming in the second quarter of 2012.
All of this is good news for Encana, as it should be able to sell its production at higher prices, generating more reliable profit margins. At the same time, the company's pipeline business should hold up well as increased economic activity in the U.S. will likely drive more demand for fossil fuels.
With investors bidding ECA higher, we now have an opportunity to generate 26% per-year returns by selling puts against the stock. As of this writing, ECA May 21 puts are trading near $0.65 per share. So by selling one put option contract, which represents 100 shares, we are able to collect $65 in income right off the bat.
Of course, by selling these puts, we are agreeing to buy shares of ECA at $21, provided the stock is trading below this level when the puts expire on May 16. Since we are receiving $0.65 per share from selling the puts, we will have to set aside an additional $20.35 per share of our own capital ($2,035 per contract) in case we are assigned the shares. This represents our net cost if we were to be required to purchase the stock -- and that means our cost will be almost a dollar below the current price of the stock.
If ECA remains strong, we will not be obligated to buy shares and will be able to keep the $65 per contract that we received. This represents a 3.2% return over the capital we set aside to buy ECA. This return will be booked over the next 45 days, and translates to a per-year rate of return of 26%.
Action to Take --> While purchasing shares outright today may wind up being a more profitable trade if ECA continues higher, the traditional stock purchase holds a significant amount of risk. Selling puts still introduces risk to your portfolio, but we can withstand a nearly 5% drop in the stock price before we would actually recognize a loss on our trade. This is a great example of how our put-selling technique generates income and also reduces the amount of risk we are taking as investors.
This article was originally published at ProfitableTrading.com:
Generate 26% a Year in Income From This Runaway Natural Gas Stock