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

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 the unemployment rate for November falling to 7.7%, a four-year low.

As people return to work, the economy should grow, and that growth will 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 (NYSE: PSX) is a diversified energy company. With 15 refineries, PSX 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, PSX is in some ways a trade on GDP.

PSX was spun off from ConocoPhillips (NYSE: 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 stock market. Earnings are expected to drop next year, but PSX still looks undervalued with a P/E ratio of 9 based on next year's expected earnings. After falling next year, analysts expect earnings per share (EPS) to grow at about 7.2% a year, a number I think we can use to define a fair value for PSX.

Some analysts believe that a stock is trading at fair value when the P/E ratio is equal to the EPS growth rate, a measure known as the price/earnings to growth ratio (PEG). Analysts expect EPS for PSX 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 PSX as a long-term investment 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 PSX 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 PSX reaches $45 by the time the put expires, I own a great stock at a fair price. If PSX does not fall that much, I earn income from the premium that I collect when I sell the put.
January $45 puts are trading at about $0.28. Each put option is for 100 shares, 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 PSX will deliver a total return of more than 10% a year in the long-term when the$1.25 a share annual dividend is considered.

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

Recommended Trade Setup:
-- Sell PSX Jan 45 Puts at the market 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 PSX will be bought at about 7 times next year's expected earnings