Recommendation No. 1: Union Pacific (NYSE: UNP)

“Sell to Open” Union Pacific August $115 Call

Option Symbol: UNP120818C115

Limit Order Price: $4.80 or more

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Growth

• Income generated: $480 per options contract (representing 100 shares of stock)
• 92-day rate of return at current stock price of $112.00: 4.3 percent (17.0 percent annualized)
• Tell your broker:

“I want to sell a covered call against 100 shares of my Union Pacific (UNP) stock. Specifically, I want to ‘sell to open’ one August $115 call for a credit of $4.80 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 Union Pacific:

Buy/Write on Union Pacific (NYSE: UNP): Buy the Stock and Simultaneously “Sell to Open” the August $115 Call

Option Symbol: UNP120818C115

Limit Order Price: $107.20 or less (stock is at $112.00 and August $115 call is at $4.80)

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Growth

• Net cost of buy/write: $10,720 per 100 shares
• 92-day return if stock does not move: 4.3 percent (17.0 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 Union Pacific (UNP) and ‘sell to open’ one August $115 call for a net debit of $107.20 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 Union Pacific (UNP) for $112.00 per share or less.”

Trade No. 2:

“I want to sell a covered call against 100 shares of my Union Pacific (UNP) stock. Specifically, I want to ‘sell to open’ one August $115 call for a credit of $4.80 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 $107.20 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 May 29th. Since this ex-dividend date is more than two months prior to August options expiration, the time value associated with the August $115 call–combined with the amount by which the $115 call is out of the money–is very likely to be larger than the $0.60 quarterly dividend and there is little chance the call holder will decide to exercise early in order to capture the dividend. 
• Why the August $115 Strike?:  According to Personal Finance editor Elliott Gue, Union Pacific–the largest North American railroad–hit a record high $3.3 billion in profits in 2011 and continues to stand by its guidance of higher full-year profits in 2012. Consequently, the future is bright. On the other hand, seasonality for transportation companies is turning bearish soon. The Stock Trader’s Almanac reports that the worst period of the year to own transportation stocks is between the middle of July and the middle of October. August expiration falls in the middle of this bearish seasonal period, so that may make it difficult for the stock to rise much above its current price of $112.00 in the next three months. The first strike price above its current price is $115.

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:

The US is in the midst of a second Golden Age for rail. According to the Association of American Railroads (AAR), total carloads transported on freight railroads in 2011 increased 2.2 percent from the previous year and 9.7 percent compared to 2009.

A railroad can haul a ton of freight over 480 miles on a single gallon of diesel fuel, compared to about 115 miles for a freight truck. Railroads’ fuel efficiency has increased 17 percent since 2005 and more than doubled since 1980.

The major railways have spent considerable capital upgrading their tracks and implementing sophisticated computer systems that optimize the flow of traffic across their networks. These improvements have increased the average speed of trains and reduced the amount of time railcars spend in terminals awaiting loading.

Such efficiency is impossible to achieve on the increasingly congested US highway system. According to a recent study by the Texas Transportation Institute, gridlock costs the US more than $100 billion and 1.9 billion gallons of fuel each year.

Because companies often save money shipping their goods by rail, these significant fuel savings don’t require government subsidies. These advantages have prompted a major truck-to-rail conversion in the US. Shippers are increasingly using rails to transport goods rather than trucks.

Rails are also finding new markets for their services. In particular, Union Pacific (NYSE: UNP) is experiencing strong growth in carloads of oil out of the Bakken Shale region of North Dakota. There simply isn’t enough pipeline capacity to transport sufficient oil out of this fast-growing producing region and many shippers have opted to use rail instead.

Additionally, the pipelines that take oil out of the Bakken primarily terminate near the Cushing, Okla. Terminal, where there’s already a glut of oil in storage. Rails offer producers the ability to ship oil all the way to the Gulf Coast, where prices are significantly better.

Union Pacific is the largest US freight railroad, with a track network spanning 32,000 route miles across 23 states. The company hit a record high $3.3 billion in profits in 2011, with 18 percent growth in net income and 15 percent growth in sales to $19.5 billion.

Union Pacific reported record first-quarter 2012 net income of $863 million, a rise of 39 percent year over year. Total freight volumes ticked up 1 percent versus the prior year, but revenue steamed ahead after the company hiked prices, levied fuel surcharges on customers and boosted volumes in some of its more profitable operating segments.

The railway operator separates its business into six segments, four of which showed positive year-over-year volume growth for the quarter. Automotive segment volumes increased 15 percent from a year ago, as deliveries of finished vehicles rose 16 percent due to consumers finally unleashing pent-up demand. However, Union Pacific’s energy segment suffered an 8 percent decline in volumes, because an unusually warm winter lowered demand for natural gas. Even so, the energy segment still managed to deliver a modest 5 percent increase in revenue.

Lackluster volumes in energy and agriculture were more than offset not just by the automotive segment’s performance, but also a 10 percent rise in industrial products shipments and an 8 percent jump in chemicals shipments.