In the past I have often mentioned Ben Grahams maxim that investing works best when it is most businesslike. I view my investing activities as a collection of businesses. My purposes with my portfolio is to attempt to identify a collection of businesses whose assets sell for less than they are worth and are capable of remaining a going concern. To institute a margin of safety I prefer those companies where the liquidation value under reasonable circumstances will yield as much or more than I paid for the securities. I also want this portfolio to generate cash flows wherever possible in the form of dividends or other cash payments. I want time and price to be on my side to the greatest extent possible at all times.
I use every tool available to me to accomplish my goals. I have no restrictions on the capital structure of the business and will buy common stock, preferred equity and even bonds of a company if the margin of safety exists and they trade for substantially less than my calculation of value. In the last decade I have learned to add options to my tool box to improve my chances of long term investment success. I think that a solid grounding of option knowledge helps me as a value investor and gives me an advantage when dealing in securities with a long term perspective.
In recent weeks I have seen several articles dealing with options trades on undervalued securities. These authors suggesting buying out of the money call options hoping the stock would appreciate and lead to large gains. The theory is that of you buy these options and the company has a strong earnings release or catches a takeover bid you could gain profits of 100% or more. While that’s true it is also true that if the roulette wheel comes up red and you have bet appropriately you can double your money. If you did not you lose your entire bet. That is not how I want to run my business.
None of the articles I ran across in my reading addressed the issues of time or option pricing. They gave no consideration to options prices or the probability of a 20% or more price move in the underlying stock in such a short time frame. The suggested options suggested for purchase all had well less than a year to expiration and in my mind that is not an investment it is just a speculation and a poor one to boot. I love to gamble but prefer race tracks where at least I can have a cocktail or two with friends while I make mathematically unsound wagers. When it comes to the markets I want to stay as business like as possible and run my portfolio like a company.
As a value investor there will be times when buying options makes a measure of sense. The vast majority of the time however it makes far more sense to be a seller of options. Many others have embraced the concept of selling options by implementing a covered call strategy. I confess that I use this approach once in a great while as a hedge but in general I am not a fan. It is not a truly efficient hedge and can lead to premature selling of issues I prefer to hold. If an issue is overvalued I prefer to just sell it rather than sell a call and hope it rises enough to be called.
The real value of options to me as a long term oriented value investor is as a seller of out of the money put options. Selling puts obligates me to buy the underlying shares at a specific price at expiration. If the stock does not fall to my stroke price or below before expiration I get to keep the premiums I collected for the sale. If the stock does fall I have to buy the stock at the strike price but I still get to keep the premium collected. Obviously the way to make this work in an optimum fashion is to make sure I want to own the underlying stock at the current price and even more willing to buy shares lower. I have to have done the research and work on the particular company and feel the stock offers a margin of safety and is sufficiently undervalued to offer a profit opportunity. Many value stocks take a long time to turn around and selling options in this manner can give me a stream of cash flow on an otherwise dormant stock. If I get put the shares I own a stock I like at a lower price than I would have obtained with an outright stock purchase.
Where a lot of people make a mistake with selling options is not going further than the stock analysis. I also want to evaluate the options and sell them for a fair price. Before selling an option take the time to run the trade through an option calculator like the free one at CBOE.Com. You are trading against an army of PHD’s with supercomputers. Don’t be today’s lunch money by selling your options at less than their fair value.
I also want market conditions to be favorable for my trades. I like to sell options when volatility is rising and options premiums are swelling. When I look at the underlying security I want the Implied and Historical Volatility to be well above the average levels of the past few months. I do not have to trade so I do not until the conditions are favorable.
If you start with underlying stocks that are safe and cheap and use common sense about options pricing they can be a successful part of your endeavors in the markets.
I have talked extensively with some of my more options oriented friends last night on the subject of using options as part of the value investor’s toolbox and the Orioles recent mastery of their hometown White Sox. My friends made some key points that are worth reviewing before anyone runs out to start selling puts on stocks in which they may have an interest. I think that using options can give me a huge advantage over investors who do not provided I stay true to the principles of deep value and time. The vast majority of the time I use options to create a long position in an undervalued stock at more favorable prices. Should the stock not fall to the price where I am forced to buy shares I keep premiums and add to my cash hoard. First and foremost you need to keep in mind that options are complex instruments with complex pricing elements and trade much differently than shares of stock. You need to do some basic research and understand the options markets before you start trading. You need to understand that using an options calculator to price options does not give us an edge in the marketplace. There are far more accurate models for option valuations built by folks who design working rocket ships as a hobby. Using the basic pricing theory keeps us form giving away too much of an edge to those rocket scientists and supercomputer we are trading against. Out edge comes from stock selection and valuation.
Never make the mistake of just reaching for fat premiums. Selling puts is very seductive. When prices are rising it seem like easy money. I did a study once that showed that selling options on the market indexes at prices 5% below last months close on a month to month basis was profitable about 85% of all months. That sounds like the closest thing to a free lunch. It would be except the losses in the few losing months exceeded the gains of the profitable ones by a substantial margin. The trap for options sellers is collecting a few premiums on the right stocks and getting enticed by the fat premiums on high flyers like Apple (AAPL) or Chipotle (CMG). You may collect some fat cash for a few months but if there is bad news out of the company or the market corrects you can lose an extraordinary amount of money very fast and end up owning a stock you have no interest in holding long term. The trick to using options to enhance profits as a value investor is to start with stock valuation not options value.
My next point is that you should never post exchange or brokerage minimum margins. Post the entire potential cost of the trade in cash when you are selling outs. If you are selling $6 puts on Radio Shack your brokerage firm will probably let you get away with putting up just a couple of grand for ten contracts. Don’t do that. Post the full $6000 needed to pay for the shares. There is a tendency to think that I have 20 grand in my account to buy Radios Shack so if I just use the exchange margin I can sell 100 contracts and not just 30. I know that sounds silly by I was a broker for 25 years and have seen the seductive allure of what looks like free cash lead some very smart individuals down the primrose path of minimum margins. If the options sell for $.50 you can take in $5000 instead of just $1500. However if the stock goes down you are going to find yourself owing more than three times the amount of stock you wanted. When I sell a put option I want the price to fall and be sold to me at the strike price. The premium is a bonus not the ultimate payoff. Post the full price in cash for every contract you sell.
There are some key difference with options trading you will need to be aware of as well. Often when I see a stock trading right around my calculation of asset or intrinsic value and I want to buy the shares at a discount to the number I will go ahead and enter a good until cancelled order 20% below the market. As long as the fundamentals do not change I can just let the order sit there until it gets filled if I choose. That’s not the case with options. The measurements used to calculate the value of the option will change daily with movements in the price and overall market direction and volatility. You need to recalculate the value every day and renter the order until you get filled. If you leave a GTC order out there odds are you will once again have the pleasure of paying for market makers lunch that day.
Options are a very powerful tool for value investors in my opinion and experience. However you need to do the homework and learn how options are valued and traded before adding these to your regular investing approach. You will find that it is time well spent and should help add to our fiscal well-being many times over the effort and cost expended.
The vast majority of the time selling puts is the best options related tool for value types to use. It just makes sense to get paid to buy a stock at an attractive price and can add several percentage points over the year. Most of the time I want to be a seller of options not a buyer. Of course there are always some exceptions to every rule and today I want to talk about those. There are two occasions where I favor buying, rather than selling options.
The first is when I want to short a stock. I have often said I am the world’s biggest chicken short. Outright shorting a stock can tie up a lot of capital and you are subject to margin calls if the position moves against you, as it usually does in my case. Some of my option savvy friends sell calls when they want to bet a stock will go down. Although that is a valid strategy a good percentage of the time I need more than one hand to count my associates who have been blown up by being short calls before a takeover or other significant event. That is just too much risk for me to take with my hard earned money and over the years I have developed my own chicken short style.
When I short a stock I look for egregious over valuation. I want to find those stocks with nosebleed price to earnings and price to sales ratios that are much beloved by Wall Street. I am of the steadfast opinion that in the long run no stock is worth 70 times earning s or 10 times sales not matter how promising the potential. The stock may hold the valuation level for far longer than one would expect, eventually gravity does reassert itself. I try to gain an additional edge by looking for things like slowing earnings momentum or decreasing earnings surprise to attempt to find a high flyer that is preparing to do an Icarus imitation.
When I locate such a stock I will either buy a put, or more likely buy a put spread. I will buy an out of the money put and then sell a lower strike price. I look for at least a 3 to 1 risk reward ratio with these trades. If I am buying a 70-50 put spread on a $75 stock like Lululemon (LULU) I do want to pay more than 6.50 net for the trade. I also want to go out as far as possible to give bad things time to happen. Six months is the absolute minimum. I use no stop loss and hold until it either trades below the lower strike and I can close at the maximum gain or it expires.
This is a tiny part of my investing approach. The total cost of put spreads is never more than 2% of my total portfolio. Frankly speaking they are bets that I hope have some decent analysis and expectation behind them. If I am really honest about it is akin to going to the racetrack without leaving the office. I win these bets on average about half the time historically so it has added a little to my pile over the years but the rewards have been more intellectual than anything else.
The only other time I am likely to buy options is when a particular stock has been hit hard during a steep market decline. On some few rare occasions I can find long term options that are very cheap. I like to buy in the money leaps that have little or no time premium and allow me to gain cheap low cost leverage on a particular stock that I think will recover over the next year or two. As an example only as the market is hardly suffering steep decline right now the Arch Coal (ACI) January 2014 $5 calls have a last price of $5. With the stock at $9.83 there is very little time premium in the options and I am not paying much for 20 months of leverage in the stock. If the market was down sharply and I could execute the trade at those prices I would be interested. The key is to pay a lot of time and pay very little time premium. It is a rare trade but can be spectacularly profitable when you find an appropriate situation.
I have spent most of this week talking about options during the day and watching the Orioles actually win baseball games most evenings. The more in depth discussion of trading options is a departure from my usual subject matter but I think it is an important one. The combination of options and value stocks is one that has a lot of potential for profits if used correctly. I have long theorized that if a pure value investor and an options expert teamed up they would create an approach that was almost an anomaly. Most option traders do not even consider the valuation of the underlying. Most value investors do not consider options a serious part of their investment toolbox. Such a combination would, in my opinion, be wildly profitable.
I have given thought at various times to finding a partner and raising money for such an approach. If I ever did then the combination trade would be a large part of my trading activities for such a fund. The combination is one of my favorite trades and I have used it at times in the past with strong results. I usually use this approach when a stock is bomber out and has fallen sharply. My most successful combinations have been one time blue chips or midcaps that have fallen into single digit midget status. When I find one I like I buy 1000 shares of stock and simultaneously sell 10 calls well above market and 10 puts below the current price.
As always valuation of the underlying stock is the most important factor in this trade. The stock has to be cheap enough to justify purchase on its own merits before I do the option trades. I also want to go as far out as the option chain will allow me. Right now most of the trades I would consider use January 2014 options to execute the combination. In no case would I go any shorter than January of 2013. The money in this trade is made over time as prices change to reflect fundamentals and premiums decay not in short term fluctuations.
This trade is as close to a win-win situation as you can find in the markets if you have the valuation correct. If the stock goes above the higher strike price the stock is called away at a profit and you keep the premiums. If the stock falls below the bottom strike you have to double your stock position by buying more shares at the lower strike offset by the premiums received. If the stock flat lines and stays between the strikes you keep the premiums and still own the stock.
To best illustrate how this trade works I will use an example. A stock many of us here on real Money have discussed in the past is SuperValu (SVU), the supermarket chain. The incredibly competitive grocery market and high debt levels have caused the stock to struggle somewhat painfully as it has fallen form near $50 in 2008 to just around $6 today. Many believe that the company will finally fight its way back to profit this year and the company will begin to see a solid turnaround. If that happens the stock price could finally stage a rally. Management gave optimistic profit assumptions and the company has attracted some attention. It is worth mentioning that in the risk section of the latest federal filing that a dividend cut was unlikely but possible. It is the first time that language has been used by Supervalu.
Top create this trade I want to use January 2014 options. I will buy the stock right here at $6.20. I am then going to sell the $10 call for $.70 or better and the $5 put for $1.3 or better. If the stock goes up over $10 in the next 20 months I will sell my shares for $10 and I keep the $2 premium for a total profit of $5.80. That work out to roughly a 55% annualized profit. If the stock says the between $5 and $10 I keep the $2 and still own the stock which is almost 20% on annual basis. If the shares fall I have to buy another $1000 shares and now own 2000 shares of Supervalu at $5.60 but I also kept the $2000 in premiums so my adjusted cost is now $4.60. Should the company continue to pay the divided I add 5.6% to my annualized returns.
The worst case scenario is that I buy a decent company at less than the all-time low price. The best case is almost doubling my money in less than two years. In my mind that is pretty close to a win-win trade.
Options and value stocks do not appear to go together at first glance. A deeper look however shows that they can combine for powerful profit opportunities.
Originally published as a series of real Money articles