Under $10 Stock Could Yield 46% a Year As It Stages a Comeback

AK Steel (NYSE: AKS) represented a bit of a bright spot in the week’s bearish market action. The company reported second-quarter metrics that included a net loss for the quarter, but still handily beat analyst expectations.

AKS lost $0.13 per share, which compares favorably to a loss of $0.30 from a year ago. More importantly, on an operating basis (taking out losses on commodity derivatives), the company actually eked out a small profit of $0.02 per share. Analysts were expecting the company to report a $0.04 loss. After a very challenging period of losses for the company, it appears that AKS is finally turning the corner toward long-term profitability.

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On the macro front, weakness is emerging for the broader U.S. stock market in what appears to be in part a reaction to stronger economic activity. On Wednesday, the GDP report showed 4% growth in the second quarter versus expectations of 3.2%. On Thursday, strong labor market data added to concerns that the Federal Reserve will allow interest rates to rise sooner than expected.

As economic activity picks up, the danger of inflation also rises — and the Fed’s primary weapon against inflation is higher interest rates. After a period of near-zero rates, an uptick in Treasury yields could cause a significant shock to the system and trigger a flight out of equities and into higher-yielding fixed-income products.

Of course, there is a tremendous amount of uncertainty in the market right now as the Fed’s future path is in question and the economic recovery is anything but certain. Consider the recent weakness in new home sales as the “devil’s advocate.” 

Uncertainty in the broader market applies directly to option prices, which tend to rise when risk (or uncertainty) is elevated. Higher option prices, of course, add to the profitability of our put selling strategy.

Today, I want to sell puts on AK Steel following the company’s favorable report. As you can see in the chart below, shares have also made a turnaround.

AKS Stock Chart

With AKS currently trading around $9, I am interested in selling the AKS Sep 9 Puts with a limit price of $0.50.

By selling these puts, we are accepting an obligation to buy 100 shares of AKS per contract at the $9 strike price if the stock is trading below this level when the puts expire on Sept. 19. For taking on this responsibility, we are being paid $0.50 per share ($50 per contract) in option premium (or possibly more if you get a better execution). To cover this obligation, we will need to set aside $850 of our own capital, in addition to the $50 in premium.

If AKS continues its bullish trend and is above $9 when September expiration rolls around, we will not be required to fulfill our obligation and the $50 in income will be ours to keep free and clear. This income represents a 5.9% return over the $850 in capital that we set aside. Since the puts will expire in 47 days, our per-year rate of return is nearly 46%.

In the event AKS is below $9 at expiration and shares are assigned, I would be happy to take a position at a net cost of $8.50 per share. The company is in the midst of a turnaround, and analysts expect it to report a full-year profit of $0.01 for 2014, compared to a $0.34 loss in 2013, and a $1.15 profit in 2015. And don’t be surprised to see these estimates revised even higher following the company’s strong Q2 report.

The stock is currently trading at about 7.8 times 2015 earnings. This low valuation reflects concerns investors have for the steel business, but those worries could be quickly alleviated if the U.S. economy continues to strengthen. So while an improving economy may be challenging for the overall market, AKS is trading at a discount. This gives us less risk for our potential long position and more room for profits as shares eventually move toward a more reasonable double-digit valuation.

Note: My colleague Amber Hestla has closed 52 straight winning trades using this strategy. You can see her entire track record and learn exactly how you can make the same winning trades yourself by following this link.