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Over the last several years, the U.S. has experienced a tremendous boom in natural gas production. This increase is largely due to the widespread use of "fracking," a process that involves fracturing rock formations and then propping open the fractures with a sand and water mixture.
Shale rock formations that were previously too difficult or expensive to drill quickly became abundant sources of natural gas. Since fracking became a mainstream method for U.S. drillers, production of natural gas has increased sharply.
Ironically, while the application of this fracking technique has allowed natural gas producers to increase the amount of gas produced, it has done little to boost the stock price of these companies. At issue is the price of natural gas, which has plummeted in the years since fracking became a widely used process.
This price decline makes sense based on the laws of supply and demand. As a growing amount of natural gas supply has entered the market, it is only natural to expect prices to decline. But while this price relationship makes logical sense, it does little to comfort investors who bought stocks of natural gas producers and have failed to see the returns expected.
One area that has seen some tremendous returns as a function of the increase in natural gas production is the pipeline industry. You see, pipeline companies typically get paid based on the volume of gas (or other product) transported, along with the distance that product travels.
Considering the tremendous increase in natural gas production, most U.S. pipelines have seen volume pick up and have benefited from the additional revenue associated with this volume. The industry is experiencing increasing profits, which should continue as the level of natural gas production continues to increase.
Today, I want to take a look at an income opportunity to benefit from this trend.
Energy Transfer Partners: Healthy Yield, Attractive Options
Shares of Energy Transfer Partners (NYSE: ETP) spent the majority of 2013 in a steady bullish pattern as the company benefited from strong demand for natural gas transportation. ETP is organized as a master limited partnership (MLP) -- a classification that allows the company to avoid corporate taxes and also requires it to pay out 90% of its taxable income to shareholders.
MLPs are very attractive to dividend investors because of their high yields and the fact that those distributions are treated favorably from a personal tax perspective. Specifically, a portion of each distribution is considered taxable income, and a portion is considered "return of capital," which is not taxed. In practice, this allows investors to defer a portion of their income from this investment, ultimately allowing their capital to work harder for them.
In October, ETP increased its quarterly dividend payment to $0.905 per share. The company currently pays annual distributions of $3.62 per share, good for a 6.7% yield.
Today, I want to use a put selling strategy that will allow us to collect income from ETP immediately and potentially leave us long the stock with a lower cost basis.
At the time of this writing, ETP is trading at $54.32 per share, and the March $55 puts are trading at $2.30. By selling these put options, we are obligating ourselves to purchase shares of ETP at the $55 strike price provided the stock is below this level when the option expires. For accepting this obligation, we are being paid $2.30 per share, and that money will settle in our account one day after entering the trade.
Since we have an obligation to buy the stock, we need to set aside $55 per share, or $5,500 per contract (each contract represents 100 shares), to be able to purchase the stock. But since we are receiving $230 per contract from selling the options, we will only need to use $5,270 of our own capital to make the purchase.
If ETP rallies from here and trades back above $55, we will get to keep the premium we received from selling the options. This represents 4.4% over a 50-day period. If you were to make a similar trade every 50 days, you could net a 32% per-year rate of return.
On the other hand, if ETP remains below $55 through March expiration, we will be required to purchase the stock. Our net cost will be $52.70, a 3% discount to current prices. It would also mean a slightly higher yield (per dollar amount invested) of 6.9%.
Selling puts on ETP is a great example of the creative ways that we can use options to enter a position more cheaply, to generate additional income, and to lower the volatility that traditional investors are forced to endure.
Note: By using a similar options strategy, my colleague, Amber Hestla, is generating payments of $1,047, $2,435, even $3,410 (and sometimes more) from nearly any stock -- even ones you already own. This free report explains everything, including names and tickers.
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