Recommendation No. 1: Discover Financial Services (NYSE: DFS)

“Sell to Open” Discover Financial Services October $36 Call

Option Symbol: DFS121020C36

Limit Order Price: $1.47 or more

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Growth

• Income generated: $147 per options contract (representing 100 shares of stock)
• 92-day rate of return at current stock price of $35.17: 4.2 percent (16.6 percent annualized)
• Tell your broker:

“I want to sell a covered call against 100 shares of my Discover Financial Services (DFS) stock. Specifically, I want to ‘sell to open’ one October $36 call for a credit of $1.47 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 Discover Financial Services:

Buy/Write on Discover Financial Services (NYSE: DFS): Buy the Stock and Simultaneously “Sell to Open” the October $36 Call

Option Symbol: DFS121020C36

Limit Order Price: $33.70 or less (stock is at $35.17 and October $36 call is at $1.47)

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Growth

• Net cost of buy/write: $3,370 per 100 shares
• 92-day return if stock does not move: 4.2 percent (16.6 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 Discover Financial Services (DFS) and ‘sell to open’ one October $36 call for a net debit of $33.70 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 Discover Financial Services (DFS) for $35.17 per share or less.”

Trade No. 2:

“I want to sell a covered call against 100 shares of my Discover Financial Services (DFS) stock. Specifically, I want to ‘sell to open’ one October $36 call for a credit of $1.47 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 $33.70 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 October 3rd . If the October $36 call is in the money at that time, there is a chance that the call owner will opt to exercise the option early in order to capture the $0.10 quarterly dividend. In such a case, an early roll of the covered call may be warranted. A $0.10 dividend is relatively small, however, so the 16 days of time value remaining between the ex-dividend date and October expiration could easily be more than the dividend and make early exercise unlikely (especially if the October $36 calls remains out of the money).
• Why the October $36 Strike?: Personal Finance lead advisor Elliott Gue has set a “buy below” target for Discover Financial Services of $29 per share. With Discover trading 21 percent above that target level, the stock has gotten ahead of its fundamentals and more upside is unlikely in the near term. The company’s second-quarter earnings were 10 percent lower than the comparable period in 2011 because of a higher accounting reserve for non-performing consumer debt. If the economy remains sluggish, bad debts may continue to hurt the company’s bottom line and cap further stock appreciation. Longer term, the company’s growth opportunities remain bright.

Price Adjustments Regarding This Trade

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

Investment Rationale for Underlying Stock:

Discover Financial Services (NYSE: DFS) is an anomaly in the world of credit cards. Unlike Visa (NYSE: V) or MasterCard (NYSE: MA), both of which represent a network of issuing banks making the loans, Discover operates a closed-loop network whereby it both issues cards and makes the loans.

Discover finances card purchases and operates a payment network in more than 180 countries through Diners International, allowing Discover to capture fees at two points in the payment process rather than just one.

Discover and other credit card issuers suffered from deteriorating credit quality and rising write-offs during the 2007-09 recession and financial crisis, but the bad news is behind the group.

Credit metrics continue to improve, as the card firms have already written off loans or cut credit lines to their highest-risk borrowers, leaving only prime borrowers on the books. In addition, a cyclical improvement in the US economy and consumers’ more conservative approach to debt has reduced loss rates significantly. 

Discover’s progress in repairing its loan portfolio has lowered the company’s provision for loan losses and helped bolster its capital position. Credit card charge-offs have declined steadily since 2009, while the percentage of delinquent accounts recently hit an all-time low.

In 2011, the stock was one of the few bright spots in the hard-hit financial sector, chalking up an impressive 31 percent gain. Year to date, the stock has jumped another 47.4 percent. Beyond that, the company is expected to generate average annual earnings growth of about 10 percent over the next five years.

In late June, Discover reported fiscal second-quarter earnings of $537 million, 10.2 percent lower than the $593 million the company posted in the second quarter of 2011. However, the drop stemmed from an 18 percent increase in expenses that resulted from a $90 million reserve added to Discover’s legal reserves to cover customers’ unpaid loans.

Second-quarter sales increased 6 percent to $1.8 billion from the same quarter a year ago, boosted by a 3.5 increase in credit card loans to $46.6 billion. Total loans increased a healthy 9 percent to $57.1 billion. The company’s quality of credit also improved, as the 30-day credit card loan delinquency rate reached a new low of 1.9 percent.

Discover Financial Services is rated as a buy up to 29 in the Personal Finance Growth Portfolio.