Stock Options Cafe

Lululemon, maker of fine athletic ware recently fell on hard times, and I’ve watched it stock fall from a high of $82 to just under $40 a share. This reminded me of the Netflix blunder, when I watched the shares tumble even though the general business was doing fine. Here, it seems the CEO made a disparaging remark about overweight people.

You can see that LULU traded above $60 for the entire year in 2013. And in my opinion, it’s oversold, likely to recover to the $60s. For this trade, I looked at the Jan, 2016 strikes, $50 and $60. This was what the trade looked like earlier this week:

This chart shows the potential profit or loss on this call spread. You can see, my intention was to buy the $50 strike, and sell the $60. The difference between the two was just under $2, so if I traded 10 contracts, I’d be risking $2000. In 17 months, if LULU traded at or below $50, it would be a loss. Like rolling snake eyes in Vegas. But at $60, I’d have $10000, jackpot. You’ll note the high bid/ask spread. It looks like I’d expect to pay $2.50, but that wasn’t the case.

I entered a limit order at at $2, but it filled at $1.70. So the spread cost me $1700, a bit better than the image for P/L shows. Just under a 6 to 1 return if the stock moves up 50%. Leverage? Yes. Disclaimer – I don’t call this investing. It’s a gamble. The question remains, is this stock down on fundamentals, or due to a short term publicity black eye? Is the chance for a 50% recovery from this low really 6 to 1? We’ll see. Stay tuned.

Today, gold dropped, quiet a bit. The GLD ETF was down over 8% when I wrote this.

This is an image of the current quote and a peek at two options that expire Jan, 2015. I then looked to see how this would look if executed as a spread trade, i.e. to buy the lower priced call, and sell the higher, same number of contracts for each one.

The prices had already changed slightly, but the chart is a great way to look at this. The $170 call is bought for $4.75, and the $180 call sold for $3.15. Net cost, $1.60. Since a contract is for 100 shares of GLD, 10 contract spreads will cost $1600 plus commission.

If GLD closes at or above $180 by January, 2015, this trade will return $10,000. Put another way, the market is offering you a 6 to 1 bet against gold returning to its all time high in the next year and a half. I know the market has no personality, no emotion, but it seems to be answering the question, “will gold hit its old highs?” with a strong answer, “not bloody likely.”

Apple reached its all time high of just over $700 this past September, but has recently dipped below $440. They say that the price of a stock has no memory, it is what it is based on today, it recent earning, and its projected earnings. That said, there are opportunities to place a bet that can get you many times your initial money if the stock recovers even just part way.

Disclaimer – The post title is Betting on Apple. With Odds of 9-2 (or 4.5 to 1). These are gambling terms and this article is not about investing, it’s about gambling. Buying a stock and selling covered calls is a bit less risky than just owning the stock, as you’ve shifted your risk down the curve a bit. Just buying options is a time constrained wager. The bet I will share is that I believe Apple will recover to $600 by January of 2015. The payoff for $2200 is $10000 if this happens. Let’s look at the details:

This chart was produced last Friday, Jan 25th. The stock was trading at $445.91. To enter this trade, I looked at the price to buy the Jan $500 calls, and they were Ask – 46.50, which meant that at $600, I’d get back $100 for a bit over a 2 to 1 return. But, it would take $700 before I saw 4 to 1. So I looked at the price to sell the $600 call, and it was Bid – $24.00. The profit/loss chart appears above. You can see that at $500, the bet is lost, but each dollar above $500 is $100 returned. So, it’s $522 to break even and at $600, the $2200 returns $10,000.

Above, you can see the trade as it was executed. I entered it as a spread order, which meant that both trades had to go through and only if the difference was the $22 I bid. $600 is a 35% rise over the next two years, $522 is just 17%. This is leverage at its best. Stock up 35%, my wager up 354%. Trades like this don’t work every time, but if you have a lucky streak, and only one in three do, you’re still making money. Personally, I view the chance of this hitting at about 50/50. On a final note, this is not my investment money. It’s money set aside to go to the casino. But since I don’t actually go to the casino, this is where I’ll wager.

News broke that Dell is in talks to arrange to be taken private.You’ll note that the present price is just below $13 with a takeover anticipated at $13.50 – $14.00.

Let’s look at the option trade on this stock. A covered call.

Buying the stock for $12.63 and selling the Jan ’14 call for $1.03 gives us an out of pocket cost of $11.60 (10% below the current price) and a return if called of 12%.

12% for a call that’s a year out isn’t the best return you’d expect. After all, you are taking on the risk of the deal falling through and the price dropping back to the recent lower sub-$10 levels. The bet here is that the deal will reach a conclusion in the next few months, and the time premium on the call will collapse to reflect the buyout price. In other words, a buyout agreement at $13.50 would push Dell to within a few cents of $13.50, and the $13 call wouldn’t trade for much over 50 cents.

Update – the deal closed and the shared were assigned on 9/26. 9 months, and a return of 12% or about 16% annualized. Not the kind of high returns options can bring us, but this trade was never intended to be that. This was a covered call for a stock that I was comfortable to own if it weren’t called.

Today, I’ll share a recent trade, another covered call. This time on Radio Shack. Let me show you the details and then I’ll walk you through how this trade might play out.

Radio Shack recently tumbled, from a 52 week high of $16.70 to a recent low of $7.15 due to a bad earnings report and weak consumer confidence. This short term drop presented a spike in volatility that may be a opportunity to use options. A Jan ’13 $7.50 call which is just out of the money was trading at nearly 20% of the stock price which is an unusually high premium. In comparison, options at the same expiration for McDonald’s will trade at less than 6% of the stock value. For the Radio Shack trade, I bought 1000 shares at $7.29 and sold 10 contracts against those shares for $1.24. My net out of pocket is $6.05 per share or $6050 for a stock currently worth $7290. In effect, I bought it at a 17% discount. On the other hand, my profit potential is severely limited. No matter how high the stock rises, I am obligated to let it go for $7.50 per share. If it trades above $7.00 or so, the call buyer may call it early to capture the 50 cent dividend which is scheduled for November. If that happens, this trade will show a 24% return in 10 month’s time.

As far as the fundamentals go, Radio Shack is not buried in debt, their cash and debt are nearly identical, and book value $8.01 per share. I don’t imagine a further crash and burn from here, but a potential takeover.

Update March 2015 – A bust. RSH went under, bankrupt. Lesson – Book value doesn’t mean everything, it’s not a guaranteed floor. On thr flip side, companies with negative book values have been known to grow, turn a profit and succeed.

Today, let’s look at another covered call trade.

Micron Technology (MU) trades at $7.10. Here is the option table for January 2013:

The $7.50 strike looks interesting to me. If you buy 1000 shares of the stock, and sell 10 of this call, your out of pocket is $5270. This is 26% below the current price. If Micron doesn’t move at all in the next 16 months, you still own the shares, but are 35% ahead. If the stock trades above $7.50, it can get called away, and the maximum gain on this trade is 42%.

A glance at key statistics shows cash ($2.4B) far higher than debt ($1.57B) and a book value per share of $8.55. Keep in mind, there’s always risk when purchasing individual stocks, this trade should be part of a well thought out portfolio. In general, these are the covered call trades I like, where the premiums are high enough that even a 15% drop in the stock price over a year’s time will still result in a profitable trade.

Note & Disclosure – I executed this trade today, and updated the numbers to reflect actual trade. The call was sold for $1.83, lower than the $1.97 above as the stock was at $7.10 when the trade occurred.

Update – 9/15/11 Bought for out of pocket $5270, 1/18/13 sold for $7491, as mentioned above, a 42% return. This was over a period of 491 days for a simple annual return of 31.2%/yr.
On Jan 18th, Micron closed at $7.89, so the stock rose 11% during this time. In hindsight, this trade was ideal. The stock closed only a bit above the strike price, so no money was left on the table. For the stock buyer to get the same 42% return, Micron would have had to close above $10. The fellow that bought the option paid me $1.97 but was only in the money for $0.39 so he lost $1.58 per share, being correct the stock would rise, but it didn’t rise nearly enough to put him in the black.

On a final note, you can see this to be a case where an option trade was less risky than simply buying the stock. Could Micron have dropped in price? Of course. Had it fallen more than 26%, I’d still have a loss. If it had gone above $10 or so, I’d have gained less than those just buying the shares. I gave up some potential gain to lower my cost. Trades like this don’t come around every day. You can see exactly why I thought this to be a valuable trade going into it. I’ll continue to share my option experience, the bad as well as the good.

I recently fielded a question asking about a trade suggested by a Seeking Alpha article Intel: Dividend Champion in the Making. It’s a basic strategy called a “Covered Call.” You know what a Call is, a Covered Call is simply when you own the stock and sell the call (“sell to open”) indication that you are willing to give up the stock for the strike price, and pocket the premium at the time of sale.

Let’s look at exactly what this trade entails. First, you buy the 100 shares on Intel (INTC), which would cost you $2138. Seeking Alpha suggests selling a Sept $23 call, which closed today bid $0.43. (At the time SA published their article, it was selling at $0.55) With 3 months until expiration, this can be looked at as a 2% boost, or an extra 8% annualized. On the other side of this trade is the buyer who sees a potential high return should Intel trade over $23 within the next 3 months.

Another way to look at this trade is that you are buying Intel at a 2% discount, but then are obligated to sell at $23 should it trade above that. If the stock is called away, your maximum gain is about 9.8%, not bad for a 3 month trade. This strategy can go either way, well chosen stocks might give you the opportunity to sell the call a number of times, but then sold when they run up, and you’d move on. A stock slowly trending sideways over the long term can provide quite the yield to you. Have you ever sold a covered call? Was it a trade you’d make again, or were you sorry you did it?

Today, I’ll talk about James Altucher‘s appearance on CNBC this week,  in which he made the case for Dow 20,000 within the next 12-18 months. I had two directions I could go with this, but for today, I’ll answer the first question I had – “If this is so, how can I use an options strategy to leverage this [insanely] high forecast?” For sake of context, and the chance this is read years from now, the Dow closed this week at 12,151, so 20,000 represents a 65% increase from this point. I’ve taken the liberty of switching to the S&P to implement the strategy I’ll discuss, as the options tend to be available in better volume at the strike prices that interest me. With the S&P at 1300, a 65% upside means Mr. Altucher is looking for about 2140 for this index. To trade on the S&P, I look to its most common ETF, the SPY.

(Note – you can right-click this image to see it more clearly) The SPY trades for 1/10 the value of the S&P, so the 65% upside would put it at 214 or so. A 65% increase sounds great, right? I will now show you how through the use of options, you can a 10 fold return if this prediction is only half right. You see, the market can have some wild swings, from a low of 666 in March of 2009 it more than doubled to its recent peak of 1344. Still, let’s look at a strategy to go for the big return with a much higher chance of success.

These are the Call Options for SPY, with an expiration date in Jan, 2013. If you buy the 170 call, you will spend $62 (options trade in lots of 100), and will see a profit once the SPY exceeds 170.62. By also selling the 175 call for $26, you reduce your cost to $36, and if the S&P closes just 34% higher from today, 1750, you will see $500 for your $36, a 10 to 1 return. If your brokerage account is set up for options trading, you can actually do this. There are two commissions involved, usually less than $10 for the two purchases, so your cost will be closer to $50 which is why I say 10 to 1. If you are convinced this rise is imminent, and willing to make a higher wager, the commission will be a far lower percent of your cost, and the trade will look like a 13 to 1 return.

Here’s a chart that may help illustrate this idea a bit better. A final note – This post should be considered an observation, not a recommendation. Think of it this way – the market is willing to bet you at 13 to 1 odds that the S&P will not be over 1750 on the third Friday of January, 2013.

For some time I’ve been thinking of launching a site about options. The idea that one can make a small bet (I’ll explain why I alternate between the word ‘bet’ and ‘investment on this site.’) and if right, can get a large return has intrigued me for 30 years, I’ve been trading options for as long as I’ve been trading stocks.

If you have no idea what options are, be patient, as I will offer articles describing exactly how they work.

If you’ve traded options, I hope to offer you a different perspective, as we each approach any investment from a bit of a different angle. I offer strategies that are less common than the simple buying or selling.

For now, the site is sparse, it seemed better to get going than to perseverate over headers, logos, etc.

Joe