Bullish options strategies for value investors

Bullish options strategies provide value investors a great set of tools to implement a bullish bias in their portfolios with time limits. It is also possible to implement strategies that mimic the level of bullishness you would like to see reflected in the portfolio. Below are the strategies that can be used:

Strongly bullish strategies:

The simplest bullish strategies involve buying calls or selling puts. Long calls or short puts on one of the ETFs covering the major markets (SPY, VTI, QQQ, etc) can be used to build a strong bullish bias that will correlate with the specific market as a whole. However investing in derivatives of the major market indexes has downsides including the fact that it is suitable only when the markets have bottomed out – determining the exact bottom is a gamble best avoided. So, it is best to use a series of non-correlated securities to implement this strategy in your portfolio. The classic dilemma that face value investors using long calls or short puts as a strategy is deciding how much to commit and timing.

Value investors generally have the defining characteristic that they are risk-averse. Basically, they are willing to sacrifice some portfolio performance, if there is a sizable reduction in the associated risk. For this reason, long calls should be preferred over short puts by value investors, as the downside is very high – you can loose a lot more than the premiums received. The only time when it makes sense for value investors to use short puts is as a chance to initiate a long position at a future point at a reduced cost compared to the current market price – the strategy has the downside that assignment is not guaranteed but atleast the premiums will be yours to keep, if that scenario plays out.

Long calls are not a compatible strategy either for risk-averse investors as they represent capital at risk - one of the outcomes of such positions is the loss of all the monies committed to the strategy. So, value investors have to come to terms with this basic fact before committing monies. Given the risk-averse philosophy, it is best to aim to keep no more than a maximum of 2-4% of their total portfolio value invested in long calls.

Deciding on the timing aspect is more art than science. It is however vital as you stand to lose all the capital if what you foresaw plays out a few days/weeks after the expiry date of your position. It is a fool’s game to predict the exact timing of anticipated positive outcomes for a security price. Even when some anticipated event occurs, macro situations can drive the security in the opposite direction temporarily. Even so, chances of success are higher when positioning based on anticipated events/dates: earnings announcement, new product announcements, litigation result, regulatory approval, and favorable macro environment.

Moderately bullish strategies:

The Holy Grail with a long call position is unlimited upside. Long call positions can be altered to a moderately bullish position by using an opposite position that reduces the overall cost. The classic way to do this is using bull call spreads – it allows reducing the cost of a long call option position by using an opposite position that limits the potential upside. Reducing the duration of the contract will also reduce the cost but that is not usually possible - value investors need to incorporate a good margin for error in their estimate of the timing of the bullish scenario playing out.

The bane of short put positions is its large downside risk. The bullish position can be altered to a moderately bullish position by using an opposite position that limits the downside risk. The classic way to do this is using bull put spreads – it allows reducing the downside risk of a short put position by using an opposite position that limits that downside.

1. Bull call spreads: Bull call spreads involve combining a long at-the-money (ATM) call position with a short out-the-money (OTM) call position (higher strike price) on the same security, in the same quantity, and using the same expiration month. You are in effect sacrificing some potential upside of your long call position by collecting some premium upfront from a corresponding short call position that is far enough out of the money so that if you are assigned, you still exit with a very good profit. As an example, say Google (GOOG) is trading at $600 and your research indicates that analysts may be overly pessimistic of the company’s prospects for next quarter. So, you bought a call option on Google (GOOG) shares at a strike price of $600 for $30 (premium of $3000) expiring next month immediately after earnings. The analyst expectations shifted as the earnings date approached and the sentiment change resulted in the stock trading at $640 two weeks from earnings. At this point, you estimate the upside is now somewhat limited to $660 or so. A good way to reduce the cost of your original position at this point is by establishing a new short long position at a strike price of $660 at 20 (premium of $2000). In effect, you have managed to reduce the cost of your original long position from $3000 to $1000 while sacrificing the upside over $660. If the stock trades above $660 at expiry, your gains are limited but still very good: ($660-$600)*100-$1000=$5000. There is not much downside protection other than the fact that you reduced the risk capital from $3000 to $1000. The classic bull call spread strategy involves simultaneously buying ATM calls and selling OTM calls on the same security and expiration month, rather than waiting for a period of time to establish the latter position. The cost reduction will be lower when using that strategy as far-out-the-money calls will have very limited premiums associated with them.
2. Bull put spreads: Bull put spreads involve combining a long at-the-money (ATM) put position with a short in-the-money (ITM) put position (higher strike price) on the same security, in the same quantity, and using the same expiration month. You are in effect reducing the downside risk by sacrificing some premium to purchase a protective put.  As an example, say Google (GOOG) is trading at $600 and your research indicates that analysts may be overly pessimistic of the company’s prospects for next quarter. So, you sold an ITM put position at $630 for $35 ($3500 premium) expiring next month, immediately after earnings –the idea is to keep the premium, when your bullish prediction plays out. The position has no downside protection. For example, if the stock dropped to $500 at expiry, you stand to loose a whopping $9500 (630-500-35), almost three times the premium received. To avoid this situation, you buy an at-the-money (ATM) put position simultaneously at $600 for $10 ($1000 premium). In this scenario, if the stock dropped to $500 at expiry, you loose only $500 ($9500 – $9000). The cost of reducing this downside risk was the put premium of $1000 you paid for the long ATM put position.

The bull spreads above are called vertical spreads as the strike price is used to implement the spread. A variation that uses the expiry to implement the spread is called calendar spreads. Longer term long calls are offset by short-term short calls.

Mildly bullish strategies:

Long positions represent a strong bullish stance on the company concerned. The strong bullish stance of a long position can be reduced to a mild bullish stance by selling covered calls. Out-of-the-money covered calls are preferred unless you think the stock price is already over-extended. The covered call premium provides a small amount of downside protection. Also, out-of-the-money covered calls provide a way to exit the stock at a nice profit, if the stock goes up. There is no downside protection beyond the call premium realized upfront. Premiums go up as the time to expiration increase but chances of getting assigned also increase. Also, a series of shorter term option positions realize more premium income compared to a leap position of same duration and so in most situations going with shorter-term duration (three months or less) is the most beneficial when implementing this strategy.

Sears (SHLD) Hometown and Outlet Stores Spin-off Rights (SHOSR): Doing Nothing is Bad!

Sears Holdings (SHLD) is spinning off Sears Hometown and Hardware and Sears Outlet (SHOS) through a rights offering whereby existing SHLD holders received the right (SHOSR) to purchase 0.218091 shares of SHOS at $15 per share. SHOSR currently trades at around $2.80. So, the market expects SHOS to have a market value of $2.80*1/0.218091 + $15 = $27.84 per share when it starts trading in October. The deal should raise around $450M for the parent company (SHLD).

SHLD holders received this subscription right in early September and the worst option is doing nothing. In that case, the right would expire worthless on October 8th. In case you have SHLD in any of your brokerage or IRA accounts, this is the time to act. If ownership of a small-cap (~$500M)  retailer with razor-thin margins (~3%) trading below book value with very low float (23M shares but majority owned by Eddie Lampbert's ESL) interests you, exercise the right. Otherwise, sell it before expiry!

In May 2012, Sears Holdings (SHLD) also announced to spin off Sears Canada (SEARF). Compared to the rights offering, this transaction was a breeze and did not require any specific action from SHLD holders. The SEARF shares showed up in the brokerage account automatically immediately after the completion of the spinoff on 11/14/2012. Here again, shareholders ended up with shares of a far less liquid entity. The spinoff worked as follows: SHLD holders received 0.4283 shares of SEARF for every share of SHLD stock held as of COB 11/01/2012.


Last Updated: 11/2012. 

Tracking David Einhorn's Greenlight Capital Portfolio: Q1 2012 Update

Below is a spreadsheet that highlights David Einhorn's moves this quarter. Please check-out our SeekingAlpha column for an analysis of the moves:

Basic Options Strategies for Value Investors

Options are an excellent tool for value investors. Value investors who rely on Fair Value Estimates (FVE) to arrive at Buy/Sell decisions tend to use a two-pronged approach:

• Bottom-up fundamental analysis, and
• Macro considerations

Rather than using a fixed FVE, value investors rely on a range of FVE’s based on the assumptions and methods used. With a range of FVE’s in place, the Buy decision can be based on a margin-of-safety around the low-point of the FVE’s and the Sell decision when the market value approaches the FVE.

Macro environment can cause the overall market to stay significantly undervalued or overvalued for extended periods of time. In times of market undervaluation, it is easier for value investors to stay fully invested while the reverse is true during periods of significant market overvaluation. Hanging on to cash under such circumstances can result in value investors missing out by a long chalk as cash holdings rarely provide significant returns. This, in essence, is the bane of long-only value investors.

Value investors would be better off with a long-short portfolio instead of one laden with longs only. Then, value investors can opt to stretch their short-portfolio when the macro picture indicates the overall market overextended and shrink the same when the macro points to the contrary. The approach is not without downsides: 

a)      Open-Ended Risk: The losses can be limitless while the returns are capped as the stock cannot dip beyond zero. For e.g., the maximum profit from shorting 100 shares of a $50 stock of ABC is 100% of the proceeds received when shorting ($5,000) – realized if the stock goes to zero. On the other hand, if the stock goes to $150 and the decision is to close the position, the loss is 200% of the proceeds received when shorting ($10,000) – theoretically, the losses have no limit as there is no ceiling for the stock price of a company.

b)      Costs: Several expenses are associated with shorting stock - the fees the broker charges for borrowing the shares, dividend payment on short position, and margin costs. A part of the cost may be offset if interest is earned on the short proceeds. The cost increases as the position is held for extended periods of time.

Options based strategies are a valuable tool for value investors. Below lists some of the most basic option strategies that can be employed:

a)      Short Puts: Short puts involve selling put options on a stock at a particular strike price. The expectation is that the stock will stay above the strike price during the option period allowing one to pocket the premium realized as pure profit. But, one is obligated to buy the stock, if and when assigned. Hence, it is best to write cash-covered puts – meaning one has the liquidity to buy the stock at the strike price. Short puts are a way for value investors to potentially enter a stock at a price they wish to enter. For e.g., say the FVE indicates stock ABC is a good value at $30 or below and the stock is currently trading at $35. An option in this scenario would be to sell put options on ABC at $30. If the stock stays over $30, the investor gets to keep the premium received. But, if it went below $30, most probably the stock would be assigned and the investor would own the shares at $30. The downside is the value of the position at the strike price, if the option was assigned. For this reason, it is best to view short put positions as though one is long on the stock at the option strike price in an amount equal to the contract size – if the sale were for 5 contracts, assume one is long 500 shares.

b)      Long Puts: Long puts involve buying put options on a stock at a particular strike price. Though the put premium needs to be paid out, it provides protection, if the investor owns the underlying shares. For e.g., say one has ownership of a stable stock XYZ at a cost-basis of $25. The stock is currently trading at $50 and the investor still thinks there is a good margin-of-safety at the current price. But, since the stock has gone up, there is an urge to protect the gains. In such a situation, long puts are value investors ally. It provides a way to protect the gains against a stock decline for the price of the premium, while keeping the upside intact.

c)      Short Calls: Short calls involve selling call options on a stock at a particular strike price. The expectation is that the stock will stay below the strike price during the option period, thereby allowing the investor to pocket the premium realized as pure profit. But, the investor is obligated to give away the stock at the strike price, if assigned. Hence, it is best to write covered calls – meaning one is long the underlying stock in an amount equal to the contract size – if selling 5 contracts ensure one is also long 500 shares. For value investors, short calls allow a way to realize periodic income on a stock. The strategy can be used against one’s long positions when the overall market and the stocks involved are fairly valued or over-extended. One is spared from selling the stock as it is unclear how long the macro situation will prevail. In this scenario, using covered calls help realize periodic income, embellishing one’s returns.

d)     Long Calls: Long calls involve buying call options on a stock at a particular strike price. The expectation is that the stock will go well above the strike price during the option period, allowing one to realize potentially huge profits in a short period of time (option period). Should the stock stay below the strike price, the call premium is lost. Value investors can apply this strategy with stocks that have a chance to go up significantly over a short period of time, should an anticipated event occur. For e.g., say the stock of a company, known to have a history of blowing past earnings expectation once every few quarters, is trading at $100. Research has narrowed down on the fact that the coming quarter is one of those quarters. In this situation, value investors can opt for long calls covering the quarterly report at a strike price of $100 for say $10. If the stock moves as expected to $130 immediately after the earnings release, the money invested have tripled. On the other hand, if the investor were to go long the same amount of shares at $100, the returns would have been just 30% following the quarter report and stock move.

Related Posts:

• Cash holdings in an investment portfolio - strategies to squeeze income for value investors
• Kelly Criterion based Strategies for Value Investing
• Covered Call Strategy for Stable Income Portfolio
• Basics of Options and Futures for Value Investors
• Basic Options Strategies for Value Investors
• Basic Futures Strategies for Value Investors
• Short Selling Strategy for Value Investors

Last Updated: 04/2012.

National Presto (NPK) - Stock Analysis

National Presto (NPK), a housewares and small appliances company that diversified into defense and absorbent products was founded in 1905 to manufacture industrial-size pressure canners. Read more about National Presto's intriguing history, business issues, finances, Quantitative OFB Rating, Summary & Recommendation at Seeking Alpha.

Praxair (PX) - Stock Analysis

Introduction:

Praxair is among the largest industrial gas supplier companies in the world. As of early 2010, its market share stood at an impressive 15% as indicated by the following pie chart (taken from Praxair’s corporate presentation document):

Their products are classified as:

• Atmospheric gases – extracted directly from air, and
• Process gases – produced through other processes.

Markets served include segments as aerospace, chemicals, electronics, energy, food and beverage, health care, manufacturing, metals, and a variety of smaller markets. Below is a pie chart showing the diverse nature of the company’s revenue streams (also taken from Praxair’s corporate presentation document):



The company has a very mature patent program with over 3000 approved and active patents. As indicated by the following achievements, they are industry pioneers:

• Pioneered the first commercial oxygen plant in the 1920s.
• Pioneered non-cryogenic air separation in the early 1950s.
• Introduced the patented CoJet technology in 1997, a revolutionary means of injecting oxygen and other gases into electric arc furnaces (EAF). The process has since become a standard for chemical energy input in EAFs.
• Commercialized oxygen-based technologies for utility boilers and steel mills in the early 2000s
• Pioneered Brazil’s first LNG plant

The screen-shot below indicates the healthy diversification of the company in terms of both distribution and sales by region:



The dark shadow plaguing the company is its history before 1992. Praxair was spun-off from Union Carbide, the company partially responsible for the 1984 Bhopal tragedy, considered the world’s worst industrial catastrophe.

Business Issues:
The company plans to achieve annual organic sales growth of 8-12% and generate 12-18% annual organic EPS growth. Of this, base business is expected to follow industrial production and achieve growth of 3-4%, applications and technology transfer to contribute 2-3%, and on-site project backlog at 3-5%. Among these, the on-site project backlog has the best visibility while the other two with their included dependencies imply associated risks. Overall, the 12-18% long-term EPS growth projection seems overly aggressive; given EPS growth was just achieved last year from cost-cutting measures.

Praxair has significant debt. Good cash flow well above what is needed to service their debt obligations is generated. The debt-to-equity ratio stands at 0.85, which is not excessively high compared to peers. Nevertheless, it entails trouble should business unexpectedly slack off for the company.

Praxair is a dominant player in Brazil and the hope is to achieve comparable levels of penetration in other emerging markets. This strategy is critical for maintaining growth, as mature markets are expected to grow modestly in the 2% range. As a commodity business, the company however runs the risk of push-back from emerging market governments as they encourage local competition – amply demonstrated by the whopping $1.3B fine Brazilian regulators slapped on White Martins, their Brazilian subsidiary. That said, the risk is indeed worth taking for growth potential is enormous and the opportunity long-term as demonstrated by the bar graph below:



Praxair is largely invulnerable to economic uncertainties as their on-site/pipeline business, accounting for a quarter of the overall revenue, has 15-year take-or-pay contracts. A limited level of immunity is available for the merchant liquid (29% of revenue) business as exclusive supply contracts are predominant. Also, Praxair is expected to benefit from certain global shifts with regards to emerging market developments, energy sourcing environmental protection:

• Infrastructure development and domestic consumption increases in the emerging economies.
• Shift to hydrogen as an energy source.
• Enhanced oil recovery initiatives that use Praxair’s products as a raw material for injection technologies.
• Coal gasification initiatives to derive chemicals out of coal require Praxair’s products.
• Alternative bio-fuels are resource-intensive compared to the use of gases Praxair produces.

These initiatives are expected to act as growth drivers to support their annual sales growth target of 8-12%.

Finances:
Below is a table summarizing Praxair’s financial position:

Year	2007	2008	2009
Revenue	9.40B	10.80B	8.96B
Net Earnings	1.18B	1.21B	1.25B
Shares Outstanding	315.49M	306.86M	306.48M
Earnings per Share (Normalized – one-time items removed)	3.62	3.80	4.01
YOY Earnings Growth	20.67%	4.97%	5.53%
YOY Revenue Growth	12.95%	14.83%	(17.04%)
Net Profit Margin	12.55%	11.20%	13.95%

Last year business dipped substantially in the wake of the global recession - Revenue fell 17% yoy but amazingly the company coped to grow earnings as the net profit margin improved yoy by an outstanding 275 basis points – the impact of a one-time tax event buoyed the effort. Still, this is incredible execution by its executive management team.

Quantitative Rating:

Below is a spreadsheet showing our quantitative rating summary of Praxair (PX). (click for an understanding of the ratings on this spreadsheet):

PX scores 7.25/10 on its ability to beat inflation: Return on Equity, Net Profit Margin, Free Cash Flow are all almost perfect. PEG ratio, a measure of valuation is however very rich at 1.86.

Corporate Abuse rating is 0/10 as their executive compensation is egregious: The CEO makes around $8M, over 250 times the average worker.

Income generation and liquidity measure is almost perfect at 9/10: PX pays a decent 2% dividend. The stock is also Optionable and very liquid.

Volatility ranking is also almost perfect at 9.33/10: the company has sizable debt and that reduced this rating slightly.

Capacity to increase dividends scored 10: the company grew earnings steadily in the last 5 years and earnings showed consistent growth history as well. Praxair’s payout ratio is very good at 39 – company has room to increase dividends. The company has very good 5-year average dividend growth at an annualized rate of 17.31%. Earnings also showed a consistent growth rate of 12.75% in the last 5 years.

The overall quantitative rating or the ‘OFB Factor’ came in at 7.12/10, which is well above average.

Summary:

Praxair Inc. has an enterprise value of $33.69B and a forward PE of 17.38. Praxair’s revenue came down significantly in the last year as the company felt the impact of the recessionary environment worldwide. Praxair is expected to grow revenue in the high single-digit range for the next two years, hinging on economic rebound. Praxair’s sales projections incorporate achieving a CAGR of 14% in the emerging market while continuing modest growth in other markets thereby increasing sales in emerging markets from the current 35% range to 45% in the next 5 years. In many of these markets Praxair’s advantage is being the first-mover and with it the chance of succeeding is high although associated risks abound.

Praxair has a PEG ratio of 1.86, which indicates valuation is high. Our quantitative analysis showed the company as having a ‘Well Above Average’ rating. Although most of our other checks showed green lights, valuation is high and we recommend adding Praxair to the watch list and consider purchase when the share price gets cheaper.