This Could Be a Great Income Trade

Warren Buffett has been a source of wisdom for many investors.

Every year, Buffett shares some of his investment philosophy in the Chairman’s Letter of the annual report for Berkshire Hathaway (NYSE: BRK-B).

Among the many important lessons he has provided over the years is the advice to only invest in companies that you understand.

Many investors follow this advice, and companies that are difficult to understand can be undervalued simply because of that. Conglomerates, or businesses with diverse and unrelated operating divisions, tend to trade at discounts to the market.

[ad#Google Adsense 336×280-IA]One reason for the undervaluation could be that investors have a difficult time valuing the different businesses.

To help investors understand the value of a company, some conglomerates spin off non-core operations.

Ingersoll-Rand (NYSE: IR) is an example of a company that is trying to increase shareholder value with a spin-off.

IR is best known for its heating, ventilation and air conditioning (HVAC) systems.

The company makes systems under brand names including Trane and American Standard.

It also offers HVAC maintenance services. This would be a relatively easy to understand business, but IR also had a security division that makes locks and electronic security systems. The relationship between the two divisions is not readily apparent.

In an effort to unlock shareholder value, IR completed a spin-off of the security division, which now trades as Allegion (NYSE: ALLE). I believe this action makes IR a great income trade.

IR has become much easier to understand without the security division, and analysts seem to believe that IR will be better off without the division. Without ALLE, IR is expected to grow at 16% a year. Prior to the spin-off, analysts had been expecting growth of 11%. The higher growth rate should lead to a higher valuation for the stock.

IR is currently trading at about $56, and with a dividend of $0.84 per share is yielding 1.2%. That amount of income might be considered low to many investors, but that can be increased with a covered call strategy.

A call option gives the buyer the right to buy 100 shares of stock for a predetermined price (the strike price) at any time prior to the expiration date. Call sellers have an obligation to sell the shares if the call buyer exercises their right to buy the stock, which they will do if the price is above the strike price when the option expires. A covered call is an option that you sell on a stock that you own. If you buy 100 shares of IR, you could sell one call contract on that position to increase the income.

With IR trading at about $56, traders can buy 100 shares of IR and immediately sell a call option expiring in January with an exercise price of $60 for about $0.50.

Because of the spin-off, there are two options contracts trading with that expiration date and strike price. I am recommending the contract with the symbol IR140118C00060000. The other contract includes shares of ALLE and trades with a symbol that begins with IR1140.

Chart inserted by Daily Trade Alert

If IR is above $60 when the call expires on Jan. 17, the buyer will exercise the option and you will have to sell at $60. Your profit on the trade will be equal to the difference in the sale price and the purchase price ($4 in this case) plus the option premium of $0.50 for a total of $4.50 per share. That would be a return of 8% in less than two months.

If IR is below $60 in January, you will have the opportunity to sell another call option and generate additional income. The current price of the option is about 1% of the stock’s price. Selling an option for that amount every two months would generate income of about 6% a year. Combined with the dividend of 1.2%, the income on this position could total 7.2% a year.

You can always close a covered call at any time by selling the shares and a “buy to close” order for the call.

Covered calls can provide high income. This income could offset potential losses in the stock or add to gains.

— Amber Hestla

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Source: ProfitableTrading