In this post I’ll be talking about a value investment strategy we implement using options at the hedge fund I manage. Please be aware that I am NOT soliciting any business for my hedge fund. This article is just being used as an example for educational purposes only. The following content was written to my partners about year ago.
I’d like share with you how we do value investing at our hedge fund, Smart Income Partners (SIP). SIP is hedge fund focused on earning income from selling options. Most people are surprised when I speak about the portfolio as being value oriented. When they hear that SIP is an option fund, they get quickly get scared and lose interest. People usually fear what they do not understand.
Probably to your surprise, SIP is more of a value investor than you may think. When choosing to place a trade for the fund, I always look at the fundamentals first. I always ask, “Is this a company that I would like to own?” I always make sure that the underlying is trading at a fair or undervalued price before considering selling options on it. Of course I’m assuming we are looking at a bullish position. We do the opposite for the case of a bearish position. Also, I check the volatility to make sure that options are selling at a level where they pay for the risk that we are willing to take.
Let me give you an example of value investing at SIP. We will use a position that we had in the fund at some point, Molson Coors. We did the fundamental analysis on Molson Coors, symbol TAP. They are a brewer that sells beer in Canada and the USA. I consider beer a consumer staple, it is consumed regularly in good or bad times. On March 21, 2012 TAP was trading at $43 a P/E of 11 and paying around a 3% annual dividend yield. In my opinion it is a company we would like to own at these prices. Our trade would be as follow: buy 100 shares of TAP at $43 per share, sell a May 40 PUT for $0.34 per share and sell a MAY 45 Call for $0.44 per share. May expiration is 58 days from 3/21/12. By the way, the trade we just did, owning the stock and selling an OTM PUT and a OTM CALL is called a COVERED STRANGLE.
Here are the possible outcomes:
Scenario 1: TAP stays around $43 and the PUT and CALL expire worthless for a gain of $0.78 per share, or 1.8% in 58 days. This gives an annualized return of 11.6%, and if you did this trade continuously throughout the year you would also receive around 3% in dividends. Giving you around 15% return for a stock that doesn’t move.
Scenario 2: TAP closes above $45 at May expiration. Then the PUT expires worthless for a gain of $0.34 per share, and the stock is called out (means we had to sell it) for $45, giving you a gain of $2 ($45-$43). Also, remember that we had collected $0.44 for the Call that was sold. Hence, in total we made $0.34 + $2.00+ $0.44 = $2.88, which is 6.5% return on $43 in 58 days. Annualized is a 41% return.
Scenario 3: TAP closes below $40, let’s say it closed at $39. This means that the Call would expire worthless, and another 100 shares would be PUT to us at $40. This means that we had to purchase 100 shares at the put strike price of $40. However, remember that we received $0.34 for the put and $0.44 for the call for a credit of $0.78. Hence, the actual cost of the purchased stock was $40 – 0.78 = $39.22. Yes, we are losing money with the stock trading at $39, but at this level we would have wanted to buy more stock. Remember that we will be collecting a 3% dividend on the stock. So, in fact at if the stock stays at $39 it would be so bad.
Remember, all of our stocks are analyzed fundamentally before doing any option operations. Would we want to own that stock? Is it undervalued? Then we set up trades that are favorable to us.
In this example, we bought at stock that we considered a good value, we collected some premium. If the stock stayed flat we made money, if it went up we made money, if it went down we lost some money but we bought more stock at a discount and would be receiving dividends as time goes by.
The covered strangle we just reviewed is a good strategy to have in your eclectic investor’s arsenal. I’ve used this strategy successfully many times, and have had no complaints.
Happy investing. Have and great week.