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This Trade Could be Your Ticket to 27% a Year Income

Posted
12/12/2012 7:00:00 AM
By: StreetAuthority
Referenced Stocks:COP;EPS;PSX

Bad news tends to dominate the headlines and we often miss the signs of good news that are buried lower on the page. One example of good news was theunemployment rate for November falling to 7.7%, a four-year low.

As people return to work, theeconomy should grow, and that growthwill benefit a number of companies. Energy companies are usually among the winners in a growing economy. These companies can be risky, though, especially if the price of oil falls, but there are some companies that are diversified energy plays.

Phillips 66 ( PSX ) is a diversified energy company. With 15 refineries, Phillips 66 offers a way to benefit if the demand for oil and gasoline rises, as it would if the economy grows. The company's 10,000 gas stations and retail outlets would benefit from an increase in the number of miles driven. And demand and prices of its chemicals will increase with gains in industrial production. With so many ways to benefit from growth, Phillips 66 is in some ways a trade onGDP .

Phillips 66 was spun off from ConocoPhillips ( COP ) earlier this year and has a limited trading history. The stock does seem to be undervalued, trading at a price-to-earnings (P/E ) ratio of about 6, less than half the average of large-cap stocks in the stockmarket . Earnings are expected to drop next year, but Phillips 66 still looks undervalued with a P/E ratio of 9 based on next year's expectedearnings . After falling next year, analysts expectearnings per share ( EPS ) to grow at about 7.2% a year, a number I think we can use to define afair value for Phillips 66.

Some analysts believe that a stock is trading at fair value when the P/E ratio is equal to theEPS growth rate, a measure known as the price/earnings to growth ratio (PEG ). Analysts expect EPS for Phillips 66 to come in at $6.22 next year. Assigning a P/E ratio of 7.2 to those earnings, the stock would have a fair value of about $45 a share. I like Phillips 66 as a long-terminvestment and would like to buy it at $45, and by selling a put I might be able to do that.

Put buyers expect to see a stock price fall. Put sellers may think that the stock price will go up or stay the same, or they may be selling because they are willing to invest in the company at the right price. Since I believe Phillips 66 would be fairly valued at $45, I can sell a put at $45 and buy the stock at that price if it falls about 17%. If Phillips 66 reaches $45 by the time the put expires, then I'll own a great stock at a fair price. If Phillips 66 does not fall that much, I'll earn income from the premium that I collect when I sell the put.

January $45 puts are trading at about 28 cents a share. Eachput option is for 100shares , and selling one put will generate $28 in immediate income.Brokers allow these types of trades with a 20%margin , or $900 in this case. If the put expires worthless, the 3.1 % income works out to an annualized rate of return of about 27%. If the put is exercised, I believe that Phillips 66 will deliver a total return of more than 10% a year in the long-term when the $1.25 a share annualdividend is considered.

Phillips 66 looks like a long-term winner, but it also looks slightlyovervalued . A put sale creates an opportunity to earn income while waiting for Phillips 66 to fall to a fair valuation.

Action to Take --> Sell Phillips 66 Jan 45 Puts at themarket price . Do not use a stop-loss. If the puts are not exercised, the premium received will be a 100%profit ; if they are exercised, then Phillips 66 will be bought at about 7 times next year's expected earnings.

This article originally appeared on TradingAuthority.com:
This Trade Could be Your Ticket to 27% a Year Income