Recommendation No. 2: Freeport-McMoRan Copper & Gold (NYSE: FCX)

“Sell to Open” Freeport-McMoRan Copper & Gold August $36 Call

Option Symbol: FCX120818C36

Limit Order Price: $1.41 or more

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Income

• Income generated: $141 per options contract (representing 100 shares of stock)
• 92-day rate of return at current stock price of $32.57: 4.3 percent (17.2 percent annualized)
• Tell your broker:

“I want to sell a covered call against 100 shares of my Freeport-McMoRan Copper & Gold (FCX) stock. Specifically, I want to ‘sell to open’ one August $36 call for a credit of $1.41 per share or more.”

• Remember: You should only sell one call option per 100 shares of stock purchased. The trade can only be done in 100-share increments (100, 200, 300, 400, 500, etc.).

Alternative Trade for Those Who Don’t Already Own Freeport-McMoRan Copper & Gold:

Buy/Write on Freeport-McMoRan Copper & Gold (NYSE: FCX): Buy the Stock and Simultaneously “Sell to Open” the August $36 Call

Option Symbol: FCX120818C36

Limit Order Price: $31.16 or less (stock is at $32.57 and August $36 call is at $1.41)

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Income

• Net cost of buy/write: $3,116 per 100 shares
• 92-day return if stock does not move: 4.3 percent (17.2 percent annualized)
• Brokers vary as to whether they call this trade a “buy/write” or a “covered stock” trade.
• Do the trade simultaneously at a single limit price, if possible. For example, if you want to buy 100 shares of stock, tell your broker:

“I want to do a buy/write trade. Specifically, I want to buy 100 shares of Freeport-McMoRan Copper & Gold (FCX) and ‘sell to open’ one August $36 call for a net debit of $31.16 per share or less.”

• Some brokers require that you buy the stock and sell the call in separate trades. If your broker is one of these, always buy the stock first and sell the call against it second:

Trade No. 1:

“I want to buy 100 shares of Freeport-McMoRan Copper & Gold (FCX) for $32.57 per share or less.”

Trade No. 2:

“I want to sell a covered call against 100 shares of my Freeport-McMoRan Copper & Gold (FCX) stock. Specifically, I want to ‘sell to open’ one August $36 call for a credit of $1.41 per share or more.”

Please note: When doing a buy/write trade in two steps rather than in one simultaneous trade, the important thing is limiting the net cost of the buy/write to $31.16 per share. The specific limit prices of the individual “buy stock” and “sell covered call” trades are just starting points and should be adjusted as needed, keeping the net cost of the overall buy/write in mind.

• Ex-Dividend Date: The stock’s next quarterly ex-dividend date is around July 12th. Since this ex-dividend date is a little more than one month prior to August options expiration, there is a modest chance that the time value associated with the August $36 call may not be larger than the $0.3125 quarterly dividend on the ex-dividend date. Consequently, if the August $36 call is “in the money” in mid-July, there is a chance that the call holder will exercise the call early to capture the dividend. We will monitor the situation and recommend an early roll of the call to a later expiration month if necessary to avoid assignment.
• Why the August $36 Strike?: According to Personal Finance associate editor Roger Conrad, Freeport-McMoRan is “the world’s fastest-growing major resource company with diminishing political risk and a strong balance sheet at its lowest price since the 2008-09 recession.” That makes the stock a solid long-term investment. Short-term headwinds exist, however. Australian miner BHP Billiton (NYSE: BHP)–which is a bellwether for the industry–recently issued a warning that demand for commodities will slow because of the European debt crisis and slowing economic growth in China. Seasonality is also turning bearish. The Stock Trader’s Almanac reports that the worst period of the year to own materials stocks is between the middle of May and the middle of October. The stock is already down significantly from its January high, so it could rebound, which is why I want to give the stock some room to appreciate (about 10 percent) back up to its 50-day moving average around $36. In the short term, I don’t expect the stock to rise much above its 50-day moving average in the next three months, so generating some option income at that level makes sense.

Price Adjustments Regarding This Trade

Stock prices are currently fluctuating and option prices fluctuate with them. Consequently, the limit prices recommended in this trade may no longer be immediately fillable by the time the issue has been published. The limit advice is valid for seven trading days, so be patient and place your limit orders as “good ‘til canceled” (GTC) for seven days.

Investment Rationale for Underlying Stock:

Freeport-McMoRan Copper & Gold (NYSE: FCX) is the world’s largest publicly traded copper and molybdenum producer, and also boasts significant gold and cobalt production capacity. With a strong track record of success and a low cost structure, it is one of the best-run companies in the mining industry.

Its major assets include southwestern US copper/molybdenum mines; the Cerro Verde, El Abra and Candelaria copper mines in South America; the Tenke Fungurume copper/cobalt mine in the Democratic Republic of Congo (DRC); the Henderson molybdenum mine in Colorado; and the Grasberg copper/gold mine in Indonesia–containing the world’s largest recoverable deposits of copper. The miner has traditionally traded at a discount because its operations in Indonesia and the DRC are situated in high-risk regions.

Freeport-McMoRan is also the rare mining stock that pays a generous and rising dividend. Most encouraging, the 25 percent increase in the May 1 payment–as with the 66 percent boost the year before and the 100 percent hike the year before that–reflect the company’s relentless and successful expansion as much as a robust price environment.

First-quarter output of gold, copper and molybdenum–a key element for high-test steel–was somewhat lower than a year ago. This shortfall stemmed from the temporary suspension of operations at the Grasberg Mine in Indonesia, which reduced copper production by approximately 80 million pounds and gold by 125,000 ounces.

Without this disruption, the company’s metal production would have held steady with year-ago levels. The company is still on target to boost annual copper production by 25 percent over the next three to four years and operates with one of the most efficient cost structures among its peers.

Successful mine development prompted management to lift the first-quarter dividend by 25 percent, despite near-term softening in the market for its primary products. The company’s realized selling price for the red metal during the quarter was $3.82, roughly 11 percent below last year’s take. Realized prices for molybdenum were 15 percent lower. Gold prices surged 28 percent from year-ago levels, though the price of this precious metal has retreated from the $1,694 per ounce it fetched during the first quarter.

Looking ahead to the rest of 2012, the company expects production costs to rise as it pushes ahead with new development and restores output from its Grasberg Mine to normal levels. That’s induced management to lower its cash flow forecast to $4.2 billion, while increasing expected capital spending to $4.3 billion for the year.

Increasing costs coupled with investor uncertainty about China’s economy have pushed Freeport-McMoRan’s shares down to a new trading range in the mid-30s, from a level in the upper 40s earlier this year and a high of nearly 60 in late 2010.

These price fluctuations are normal for a company that produces natural resources. As such, investors now have the opportunity to buy the world’s fastest growing, major resource company with diminishing political risk and a strong balance sheet at its lowest price since the 2008-09 recession.

The stock provides income, growth and a potential hedge against inflation. Freeport-McMoRan Copper & Gold is rated as a buy below 42 in the Personal Finance Income Portfolio.