How to Make Income on British Petroleum — Even Without a Dividend

Due to the oil spill in the Gulf of Mexico, British Petroleum (BP) announced it is going to create a $20 bill fund to compensate victims and also cancel shareholder dividends for three quarters.

British Petroleum’s current annual %dividend is in the neighborhood of 10%. For those investors invested in BP depending on the dividend, this could be traumatic, especially if they don’t want to sell their BP stock because of tax reasons.

What should an investor stuck in this situation do?

Well, one thing they might do is to enter covered call positions for BP. A covered call investment consists selling a call option against a stock. The covered call strategy can be considered similar to renting out a house, except with stock.

For example, a covered call position for BP for the 2010 July call option with a $31 strike price has a potential return of 8% – and that’s in only 30 days! An investor accustomed to receiving BP’s dividend could potentially make up the difference for the loss of income due to canceled dividends in a couple of months. Another nicety for an investor with existing BP stock entering a covered call position is that is does not require any additional capital!

A profit/loss graph for three contracts of this covered call position is shown below:

A downside to this strategy is if the price of the BP stock were to increase, then the investor would not participate in the price appreciation of the stock. But, it doesn’t look like the price of BP’s stock is going to rise anytime soon, and if BP’s stock price does increase, then the covered call position can be rolled up in price in order to potentially generate more income and prevent the BP stock from being called away.

To enter the covered call investing position an investor would purchase the stocks in multiples of 100 shares for their trading portfolio and sell one call option for each 100 shares of stock purchased for their personal stock portfolio.

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Investors concerned the price of BP’s stock might continue to decrease might consider entering a collar position instead of a covered call position. A collar position is basically a covered call position combined with some downside protection. The downside protection is provided by a put option. The amount of downside protection can be selected up front. For example, an investor might be comfortable with a loss of 8% for BP. Based on this a collar can be entered for the covered call mentioned above by purchasing a 2010 July put option with a 27.5 strike price. The potential return of the collar is 3.5%, which is less than the 8% return of the covered call, but the position is protected against a drop in BP’s stock price of greater than 8%. The collar with a 3.5% return could still enable an investor to make up for the loss of BP’s dividend, but within three months instead of two months as is the case with the covered call.

A profit/loss graph for three contracts of this collar position is shown below:

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[tags] oil spill, Gulf of Mexico, BP, British Petroleum Co. [/tags]