Welcome to Oaktree Investment Advisors' Covered Call Focus blog, a place for information and education about the strategy of covered call writing in combination with business cycle analysis as a
means to reduce risk and increase income in a diversified portfolio. This strategy will be used to select target investments that will be identified and discussed weekly.
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Home Depot (HD) is a big box store that supplies building materials, home improvement, and lawn and garden supplies and tools to consumers all across the United States as well as in Mexico, Canada, and Puerto Rico. The company, founded in Marietta, Georgia in 1978 has over 2,200 locations and is America's largest home improvement retailer.
Home Depot has a market capitalization of $108.67 billion with 1.46 billion outstanding shares.
Home Depot currently pays a $0.39 quarterly dividend for a current yield of 2.1%.
With a beta of 0.87, HD currently trades with approximately 13% less volatility than the current market.
Back in May we had our original strategy on HD called away. We said that due to the P/E of HD, we really didn't want to jump in with that valuation, and decided to wait for a pullback and some consolidation before returning to the stock. While the P/E has only dropped by 2, a small pullback has occurred, but no real consolidation has been built in yet. So why are we deciding to recommend Home Depot now?
This week has been a turbulent week for the market, and many analysts believe that the drops in the indices are a turning point in reaction to the perceived hawkish comments coming out of the Fed. This indicates that we can have as much as a 5-10% downward correction (maybe more) before the selling is over. While a lot of this might just be panic selling by traders with itchy trigger fingers, in times of market distress there's one axiom we like to live by when having to put money to work: Quality is everything.
Home Depot remains a high quality company, and a great targeted stock for the Covered Call strategy. Despite what many fear is the end of the housing rally due to rising interest rates, we are still bullish on the condition of the housing market. We believe despite any hawkish comments out of the Fed, that they will not let the housing market - a major key to this, and any, economic recovery - to falter. If that premise remains sound, HD as the leader in the home improvement sector, will continue to be profitable.
But when faced with a possible correction in the market, we tailor our Covered Call Strategy to provide additional downside protection. That is why we are recommending the November 2013 $65 in-the-money Call. This puts you with a cost basis of a little over $63, creating more than $10 in downside protection. If the stock doesn't dip that low and gets called away then you pick up an annualized yield that is more than twice that of the 10-year treasury bond, without the same level of risk and worry that bond prices will continue downward. It is a defensive play, but to find in income and put money to work in a market that might be tipping down into a correction, a Covered Call strategy such as this can help provide the protection you need. That is why we are recommending buying HD and selling the November 2013 $65 in-the-money Call.
Buy 100 shares of HD @ $73.99 = $7,399 + Commission ($12.95) = $7,411.95
Write 1 HD November 2013 $65 Call @ $1,035 - Commission ($8.70) = $1,026.30
Note: Prices may vary from the time of post. Actual commissions paid will vary returns.
Static Return (Not Called):
(Call + Dividend)/Stock Price X (Days/Year)/Days to Expiration
(10.26 + (0.39))/74.12 X (365)/149
= 35.20% Static Return
(Call + Dividend + Strike Price - Stock Price)/Stock Price X (Days/Year)/Days to Expiration
(10.26 + (0.39) + 65 - 74.12)/74.12 X (365)/149
= 5.06% If-Called Return
Disclosure: Clients and/or principles of OakTree Investment Advisors may or will have an investment in the above positions, but only on the the same sides of the trades. The above numbers are analytic estimations based on information known at the time of this post. OakTree Investment Advisors does not guarentee the above, or any, result. All investment decisions should be made based upon individual’s personal investment goals and risk tolerance.