Investment thesis: Last month we recommended that investors sell a covered call on Canadian National Railway (TSX:CNR, NYSE:CNI). We closed this position on June 21, for a profit of 38%.

The company’s fundamentals as described previously have not changed, but the share price bounced back over the past few weeks. We consider the current level as appropriate to reinstate the original strategy.

Let’s recap the situation: CNR has performed very well over the past few years, handsomely beating the overall Canadian market and its North American railroad peers. This is a top-quality operation, but we feel that the valuation is full with a P/E ratio of 16 times 2016 estimated earnings, a dividend yield of 1.9% and a fair value only slightly above the current price. Freight volume has also been declining over several quarters — and while volume is not the only driver of profitability, the slowdown does create downside risk for profit growth. We expect the stock price to move sideways to down until freight volumes start to recover.

Option Strategy: Sell to open a covered call option with a strike price of C$84 and expiry on 16 September 2016 at or above C$0.65 per option. This will yield a C$65 premium per option (C$0.65 x 100). In addition to the option premium, the shareholder will earn the dividend (C$0.375 per share) before the option expires (except if the call is assigned before the dividend registration date) plus any capital appreciation up to the call strike price. [The most similar U.S. call option on CNI will be the US$65 strike with expiry on 21 October 2016.]

Outcomes: If all goes according to plan, the option will expire worthless on 16 September (i.e., the share price stays below C$84), the income yield will be enhanced to 2% over the 71-day holding period (which is the equivalent of a 7.3% annualized yield, vs. a 1.3% dividend yield on holding the common stock only). In addition, the strategy will allow for a capital gain of up to 5.6% for a total maximum return of 6.9% until the expiry of the option. An early exercise of the option (assignment) by the option holder could prevent the dividend payment to the option seller; in that case, the total return would not include the dividend.

The graph shows the possible outcomes for a range of CNR share prices at the expiry date. If the share price ends above the strike price at expiration, the option seller will have to deliver the covered shares and will effectively lose any capital appreciation above the strike price. The total return in that case would be the equivalent of the gain up to the strike price plus the dividend plus the option premium. So if the share price ends at C$86, the total return on the pricing metrics indicated above will capped at 6.9%.