This Pharma Stock Could Yield 37% Annual Returns for Income Traders

With the market becoming more volatile, our covered call strategy is becoming more attractive for two reasons:

  • Higher volatility naturally boosts the price of option contracts. So as we sell calls against our positions, we receive higher premiums (giving us better annualized returns).
  • As the risk of owning stocks picks up, our strategy helps investors protect their capital and even collect healthy income despite falling market prices.

Today, we’re going to take a look at a covered call trade in a very strong pharmaceutical stock.
#-ad_banner-#I’ll show you how to make a 37% annualized return. Of course, our position will accept much less risk than a traditional stockholder would be forced to deal with.

Attractive Valuation With a Volatility Premium

There are basically two types of pharmaceutical stocks. Those with an established line of drugs that generate a stable stream of income, and those that are developing new products (and thus have a higher degree of uncertainty and potentially much higher payoff when their prospective drugs are approved).

Warner Chilcott (NASDAQ: WCRX) fits into the first category with a stable product line and a very predictable profit margin.

The company focuses on four different areas of expertise:

  • Women’s health
  • Gastrointestinal
  • Urology
  • Dermatology

This product mix is attractive because it means that the company is diversified enough to withstand competition in any one of its product lines, but it has enough focus to truly benefit from strength in one or more of these four areas.

More importantly, the stock is trading at a very inexpensive valuation. The company is expected to earn $3.28 per share this year, and yet the stock is trading at just $13.40 per share.

This leaves the stock with a P/E of 4.1 — meaning investors only have to pay $4.10 for every dollar of annual earnings the company generates. By comparison, the major pharmaceutical companies such as Merck (NYSE: MRK), Pfizer (NYSE: PFE) and Eli Lilly (NYSE: LLY) are all trading with double-digit P/E multiples.

With this cheap valuation, the risk of a significant drop in price is pretty low. Of course, there are no guarantees (except death and taxes), but I expect WCRX to hold up well even in a down market. If the major indices start to fall, investors will likely take more of an interest in WCRX because of the company’s stable cash flow.

Warner Chilcott currently trades near $13.40 and the May 13 calls are offered at $0.90. So if we buy the stock (in 100-share lots) and sell one call contract for every 100 shares, our net cost for the trade is $12.50 (the $13.50 buy price less the $0.90 we receive for the calls).

It’s interesting to note that our net cost is well below the lowest price of the most recent pullback for the stock (see chart below). This means that WCRX would have to fall farther than it has over the last several months for us to recognize a loss on this position.

Assuming WCRX continues to hold steady (or simply does not fall below $13), we will be obligated to sell our stock for $13.00 per share when the calls expire. This represents a loss of $0.40 on the stock itself, but remember, we sold the call contracts for $0.90 per share, so our net profit is actually $0.50 per share.

Compared to our net investment of $12.50, this represents a 4% profit. And since there are only 39 days between now and expiration, this compounds out to an annualized return just above 37%!

Of course, if WCRX does not hold above $13, our gain could be less — and $12.50 represents a breakeven point for this trade. But it would take a significant pullback in the stock for this to happen — and we would then have the opportunity to sell new calls against the position for more income.

As always, I love hearing from you. Please let me know if you’re participating in this trade, or others that we have already recommended.  Simply email and mention the covered call articles.

We have less than two weeks until the April covered call setups expire. I’ll be tracking these positions, and for any of our shares that are not called away, we will determine whether to sell new contracts against the positions or to close them out and move on to other opportunities.