Today’s trade idea is with Caterpillar Inc. (CAT) — the manufacturer of construction and mining equipment that has improving fundamentals, a strengthening balance sheet, and could have faster dividend growth in the future.
Shares yield 2.27% today, but by selling a covered call here we can boost our income much further — generating an annualized yield of 17.3% to 32.5%.
As we go to press, CAT is selling for $137.28 per share and the December 1 $139.00 calls are going for about $1.95 per share.
Our trade would involve buying 100 shares of CAT and simultaneously selling one of those calls.
By selling a call option, we would be giving the buyer of the option the right, but not the obligation, to purchase our 100 shares at $139.00 per share (the “strike” price) anytime before December 1 (the contract “expiration” date).
In exchange for that opportunity, the buyer of the option would be paying us $1.95 per share (the “premium”).
There are two likely ways this trade would work out, and they both offer significantly higher income than what we’d collect if we relied on the stock’s dividends alone.
To be conservative, we don’t include any dividends in our calculations for either of the following scenarios. The annualized yields are generated from options premium and applicable capital gains alone. So any dividends collected are just “bonus” that will boost our overall annualized yields even further.
Let’s take a closer look at each scenario…
Scenario #1: CAT stays under $139.00 by December 1
If CAT stays under $139.00 by December 1, our options contract would expire and we’d get to keep our 100 shares.
In the process, we’d receive $195.00 in premium ($1.95 x 100 shares).
That income would be collected instantly, when the trade opens.
Excluding any commissions, if “Scenario 1″ plays out, we’d receive a 1.4% yield for selling the covered call ($1.95/$137.28) in 30 days. That works out to a 17.3% annualized yield.
Scenario #2: CAT climbs over $139.00 by December 1
If CAT climbs over $139.00 by December 1 our 100 shares will get sold (“called away”) at $139.00 per share.
In “Scenario 2” — like “Scenario 1” — we’d collect an instant $195 in premium ($1.95 x 100 shares) when the trade opens. We’d also generate $172 in capital gains when the trade closes because we’d be buying 100 shares at $137.28 and selling them at $139.00.
In this scenario, excluding any commissions, we’d be looking at a $367.00 profit.
From a percentage standpoint, this scenario would deliver an instant 1.4% yield for selling the covered call ($1.95/$137.28) and a 1.3% return from capital gains ($1.72/$137.28).
At the end of the day, we’d be looking at a 2.7% total return in 30 days, which works out to a 32.5% annualized yield from CAT.
Here’s how we’d make the trade…
We’d place a “Buy-Write” options order with a Net Debit price of as close to $135.33 ($137.28- $1.95) as we can get — the lower the better. Options contracts work in 100-share blocks, so we’d have to buy at least 100 shares of Caterpillar Inc. (CAT) for this trade. For every 100 shares we’d buy, we’d “Sell to Open” one options contract using a limit order. Accounting for the $195 in premium we’d collect, that would require a minimum investment of $13,533.
Phil Lamanna and Greg Patrick
P.S. How safe is CAT’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 63. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, CAT’s dividend appears safe, with a unlikely risk of being cut. Learn more about Dividend Safety Scores here.
P.P.S. We’d only make the above high-yield trade if: 1) we wanted to own the underlying stock anyways 2) we believed it was trading at a reasonable price 3) we were comfortable owning it for the long-haul in case the price drops significantly below our cost basis by expiration and 4) we were comfortable letting it go if shares get called away. To be mindful of position sizing, except in rare cases, the value of this trade wouldn’t exceed 5% of our total portfolio value. In addition, to minimize taxes and tax paperwork, we would most likely make this trade in a retirement account, such as an IRA or 401(k).
Please note: We’re not registered financial advisors and these aren’t specific recommendations for you as an individual. Each of our readers have different financial situations, risk tolerance, goals, time frames, etc. You should also be aware that some of the trade details (specifically stock prices and options premiums) are certain to change from the time we do our research, to the time we publish our article, to the time you’re alerted about it. So please don’t attempt to make this trade yourself without first doing your own due diligence and research.