Covered calls might be the most powerful wealth building tool you’re currently not using. This simple technique lets an investor potentially double or even triple their existing passive income from a stock, with only a marginal amount of extra work. Yes, there are trade-offs, but they pale in comparison to the reward.
Let’s take a closer look at how you can turn Inter Pipeline Ltd. (TSX:IPL) from an 8% yield into something much higher. Who couldn’t use a nice raise?
Why Inter Pipeline
Inter Pipeline is an energy infrastructure stock that doesn’t get the same attention as its larger peers. Which is a shame, as the company has plenty going for it.
The company’s main asset is a network of pipelines that transport bitumen from the oil sands to refineries near Edmonton. Approximately 50% of earnings come from these pipelines, which were specifically built to accommodate more capacity. They’re about 50% full today.
The rest of earnings come from the company’s natural gas processing facilities, conventional oil and natural gas pipelines, and fuel storage assets in Europe. It recently spent US$270 million to expand its European base.
Inter’s latest expansion project is a big one. It plans to spend $3.5 billion to build the Heartland Petrochemical Complex, a massive plant that will convert propane to propropylene, which is one of the leading polymers used for various types of plastics. If everything goes according to plan, this plant will have exceptionally low costs compared to the competition, thanks to its proximity to plenty of cheap raw materials.
This new expansion is expected to add some $500 million to annual EBITDA upon completion, which is expected by the end of 2021.
Inter’s asset base truly is world class, and earnings show it. The company has consistently increased its bottom line on an annual basis, which it passes onto investors in the form of an ever-increasing dividend. The payout has doubled over the last decade, increasing from $0.85 to $1.71 per share on an annual basis. That’s good enough for an 8% yield today.
Covered call income potential
And 8% is already a great yield, but we can do much better with a covered call approach. Here’s what you do. Step one is incredibly easy; all you need to do is buy the stock.
It gets a little more difficult for step two, but only marginally. You then need to go to the option market and sell an Inter Pipeline call option. You’ll immediately receive the premium in exchange for taking on a very important obligation.
It’s easier if we look at a real-life example. The February 15, 2019 $22 call option last traded hands at $0.12 per share. If an existing Inter Pipeline shareholder went and sold that option today, they’d immediately receive that income in exchange for agreeing to sell their shares at $22 each.
There are two possible conclusions to the trade. If Inter Pipeline shares trade under $22 each on the 15th, the option expires worthless and the investor gets to pocket the $0.12. This is the ideal outcome. You’ve created income without any adverse effects.
The other way this trade ends is Inter Pipeline shares end up above $22 each. This isn’t the end of the world either, as that means you’ve made a profit. The stock currently trades at $21.15, which means you’d be looking at a profit of $0.97 ($0.85 in capital gains and $0.12 in option premiums). That’s a profit of 4.6% in less than a month.
Remember, Inter Pipeline pays a generous monthly dividend of $0.1425. If we add the option premium onto that an investor is looking at a potential return of $0.2625 every month by doing this trade, which works out to a 14.9% annual return.
An investor doesn’t have to limit themselves to doing this with Inter Pipeline, either. Any monthly income stock will do, as long as it has corresponding options. Here’s how you can turn one of Canada’s largest oil stocks into an income stream worth more than 30% annually.
Simply put, covered calls are a powerful way for income investors to goose their total returns. You can’t afford to ignore this strategy.
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Fool contributor Nelson Smith owns shares of INTER PIPELINE LTD.