This Trade Could Deliver a Potential 32% Annualized Return

yield-2-stockphotoAfter more than five years of a bull market, valuations are getting a little stretched, and it is harder to find good prices on best-of-breed companies. That is where earnings season and one of my favorite option strategies comes in.

As a long-term investor, I can look past short-term weakness around a poor earnings report. Sometimes a miss offers a chance to load up on shares at a discount. Other times, a rally in the face of “bad” news is a sign of strength. Regardless, the heightened volatility around earnings boosts the premiums I get from selling options.

One of my favorite long-term picks just missed earnings estimates.

[ad#Google Adsense 336×280-IA]Potash Corp. of Saskatchewan (NYSE: POT) is the world’s largest fertilizer producer by capacity.

It is the leading producer of potash, responsible for approximately 20% of global capacity, and one of the largest producers of nitrogen and phosphate.

It is these three chemicals that help farmers increase the yield on their crops and feed a hungry world.

On Thursday, the company missed third-quarter EPS expectations by $0.04, reporting earnings of $0.38 per share on revenue of $1.64 billion.

While potash sales volume increased by 29% from the same quarter last year, prices for the nutrient fell 8.5% on weakness in agricultural commodities.

Shares fell as much as 2.6% following the report, but buyers swooped in and the stock finished the day off just 0.7%. This is a sign that a bottom is already in. Indeed, shares rallied 4% on Friday, and POT is up 8% from its mid-October lows.

If you missed the sale, don’t worry. There’s another way to get in at a discount.

8 Billion Reasons for Long-Term Upside in Potash

While lower crop prices have hit everyone in the agricultural sector hard, the longer-term story for Potash is strong.

A new paper published by the United Nations Population Division is shattering expectations for global population growth. Estimates that previously called for growth to start levelling off are being questioned. They now predict the global population will increase from 7.2 billion today to 8.1 billion by 2025 and 9.6 billion by 2050.

Feeding the world’s growing masses will put huge demands on agricultural producers. Researchers backed by the Institute on the Environment estimate we will need to double global crop production by 2050. That will require 2.4% annual growth in crop yields. This compares with about 1.4% current average annual growth across the four staple crops in the United States. What’s more, some research points to lower crop yields due to extreme weather patterns.

Increasing crop yields against less favorable climate conditions will only be possible through the use of nutrients — nutrients that Potash will provide.

The company raised its forecast for global shipments and narrowed its 2014 earnings guidance to $1.75 to $1.85 per share. Management also said future global demand for potash fertilizer should hold steady with this year’s level.

Over the long term, earnings should continue higher on global fertilizer demand. In the meantime, POT rewards investors for their patience with a 4.1% dividend yield.

Generate Income and Get the Chance to Buy POT at a Discount

I use a put selling strategy to establish almost all of my positions in stocks at a discount.

By selling a put option on a stock, we are agreeing to buy 100 shares per contract at the option’s strike price if shares are below that price when the option expires. For accepting the obligation, we are paid a premium, which lowers our cost basis even further. If shares are above the strike price at expiration, that premium is ours to keep free and clear.

With POT trading for $33.96 at the time of this writing, we can sell the POT Dec 35 Puts for a limit price of $1.60 each ($160 per contract). If POT closes below the $35 strike price at expiration on Dec. 20, we will be assigned shares at that price. Since we will receive $1.60 in options premium, our actual cost basis is $33.40 per share, a 1.6% discount to the current price.

I expect POT to rise above the $35 strike price before expiration, but if it does not, I would be happy to take a position in the stock at this level for its longer-term upside potential. When setting up the trade, we will need to put aside $3,340 of our own capital for every put contract we sell, plus the $160 we receive from the sale, in case we are obligated to do so.

If POT ends up closing above $35 on expiration as expected, we keep the $160 in premium for a gain of 4.8% over our $3,340 in capital set aside in just 54 days. If we were able to make a similar trade every 54 days, we would generate a 32% annual rate of return.

POT has solid support below and long-term upside potential. I would continue to sell puts until the stock rebounds to $38, just below its 52-week high, or I get assigned shares, at which point I would start selling covered calls on the position to generate even more income.

— Joseph Hogue

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Source: Profitable Trading