Dark Horse Traders’ Hedge: Time to Evaluate Buy/Write on GCI, MIPS and SNP
Thu, Oct 20, 8:34 PM ET, by Scott Brown, Sabrient.com
Time to Evaluate Buy/Write on GCI, MIPS and SNP
By Scott Brown, President, Sabrient Systems
Time, why you punish me?
Like a wave bashing into the shore
You wash away my dreams
Time, why you walk away?
Like a friend with somewhere to go
You left me crying
Can you teach me about tomorrow
And all the pain and sorrow running free
Cause tomorrow's just another day and I don't believe in time
Hootie and The Blowfish
Philosophically, I agree with the intended meaning of the lyrics of "Time" by Hootie and The Blowfish. As someone who is closer to AARP than to college graduation, which is receding rapidly in the rear view mirror, "Time, why you walk away?" is taking on a whole new meaning. However as an investor who sells "time" through options, I tend to project the lyrics "Time, why you punish me?" at those who buy options.
Alas, we have three positions we sold "time" on and need to evaluate them "like a friend with somewhere to go." Typically, the stock market follows the adage "Tomorrow's just another day and I don't believe in time"—except as it relates to options and, particularly, option expiration date. So with that in mind, we need to make some decisions tomorrow.
One last sidebar on lyrics: "You left me crying . . . and all the pain and sorrow running free." This thought takes me to the news out of the Greek Parliament today giving final approval to an austerity law cutting wages and hiking taxes. There is an old, somewhat morbid, saying about "The beatings will continue until moral improves," and I suppose it sadly meets reality here. This weekend's 3 days of emergency meetings by European "leaders" likely won't shed any new light on how—or if—the 22-month crisis will be solved, but is worth paying attention to as a backdrop to our recommendations. It is a good idea to continue to hold exposure to the VXX as a hedge against any shockwaves from the meeting.
Gannett Communications, Inc. (GCI) was recommended (speaking of "Time") way back on July 26, 2010 and is an excellent example of how selling time turns a value stock into a yield stock. The past doesn't really play a role in our decision about what to do with the options we hold for tomorrow's expiration date, but is worth discussing as a case study on how the buy/write strategy unfolds.
The premise in July 2010 was that we believed GCI was a value stock at that time, and one we were willing to have exposure to on the long side. Consistent with our approach to using the selling of time through options, we recommended buying one-half the number of shares we were willing to own at $14.52 and selling a Jan 2011 $15 call ($1.75) and put ($2.25) for exposure to the other one-half position. In theory, if the shares were "put" to us in Jan 2011 we would take in the time premium and then hold the full number of shares we were willing to own in July 2010.
As you will see, in practice, with all things being equal, we normally roll the options forward to future expiration dates and capture the premiums. Rather than putting you through my rambling as to how each position was reviewed, I will include a table and links to the published article on each. The point is to demonstrate how you can sell time and make a profit on a stock that has otherwise dropped $4 in share price while owning it, as we've done with GCI.
- January 12, 2011
- Cover Jan 11 $15 put for $.49
- Jan 11 $15 call expires (net earned on Jan 11 buy/write $3.51)
- April 7, 2011
- Cover Apr 11 $15 put for $.37
- Apr 11 $15 call expires (net earned on Apr 11 buy/write $1.93)
- June 30, 2011
- Cover Jul 11 $15 put for $.84
- Jul 11 $15 call expires (net earned on Jul 11 buy/write $1.81)
The options expiring Friday, October 21 are the Oct 11 $15 put (sold for $2.10) and Oct 11 $15 call (sold for $.84). Obviously, with GCI closing at $10.60 on Thursday, October 20, the call will expire again.
GCI remains a solid value stock trading at a forward P/E of 4.86, with a projected 5-year earnings growth of 6% and $682 million of leveraged positive cash flow. The Phil Davis Buy/Write Strategy works the best on GARP or value stocks. The premise is to enter one-half of the position at a discount to the current market (for us, this was July 26, 2010) and earn a time premium, working our cost basis close to zero; then just sell covered calls on the stock quarter after quarter until it is called away or we change our mind on the underlying value.
In this real life example, by accepting the put on the other one-half position at $15 we will now own the number of shares we were willing to own on July 26, 2010 with a cost basis of $4.56. (Here's the math: $14.52 paid for one-half on 7/26/10 + $15 paid tomorrow, 10/21, for one-half - $3.51 earned Jan 2011 – $1.93 earned Apr 2011 – $1.81 earned June 2011 – $2.95 earned Oct 2011.)
If I didn't garble my message too much, the takeaway here is that we wanted exposure to GCI in July 2010 at $14.52. GCI closed today at $10.60, which on a typical buy-and-hold strategy would have resulted in a -27% return to date. By being a seller of time/options, we have earned nearly $10 in option premiums while having the exposure we desired. At this point, we have the full number of shares we have been willing to own, and now we can turn the position to a pure covered call and enjoy a +1.9% forward dividend yield.
The recommendation is to sell the Jan 2012 $11 call for $0.85, which drops our cost basis below $4. If you are just now considering entering GCI, you would want to use the Jan 12 $10 call and Jan 12 $10 put.
MIPS Technologies, Inc. (MIPS) was recommended on April 28, 2011 at $8.17 for very different reasons than GCI. At that time, MIPS had just missed earnings and had guided lower, culminating in a 24% haircut to the share price. We were interested in utilizing the Buy/Write Strategy to get exposure to the mobile-computing market through MIPS. Much like the market, we can never be sure where the bottoms or tops are in stocks or the market, so we try to maintain a hedge to provide alpha in any market (see article Any Way the Wind Blows).
MIPS is a much different proposition that GCI. MIPS is considered a growth stock with 5-year projected earnings growth of 19% and a forward P/E at today's (10/20/11) closing price of $5.02. Given this profile and the premise behind attempting to get long exposure to MIPS at a 15-20% discount in April 2011, our current recommendation is to recognize the Oct 11 $9 call premium ($.80) and Oct 11 $9 put premium ($1.60) and accept ownership of the full number of shares. This allows us to hold the shares as a growth component of our diversified and hedged portfolio. As the market and the company turn the earnings corner, we can re-evaluate the options available to earn "time" premium on MIPS.
China Petroleum & Chemical Corp. (SNP) was recommended on October 20, 2010 at $96.54 using a simple covered call approach to earn premium on having long exposure to an energy stock. SNP closed today at $91.43 and still has a company profile which is attractive for our portfolio: a forward P/E of 5.51, operating cash flow of $22.1 billion, and a forward dividend yield of 2.9% (Remember when that would be disappointing?). The negative leveraged free cash flow of -$260 million is a slight concern, but the company has $2.3 billion in cash. Again, I will provide a bullet review of the covered calls and recommendations since Oct 2010.
- January 18, 2011: Cover Jan 11 $100 call for $1.95 (sold for $4.40, net profit $2.45)
- April 13, 2011 : Cover Apr 11 $100 call for $3.35 (sold for $6.30, net profit $2.95)
- June 30, 2011: Cover Jul 11 $100 call for $2.20 (sold for $7, net profit $4.80)
The current Oct 11 $100 call will expire tomorrow with no action necessary yielding a net profit of $5.50. This real life example on SNP demonstrates how we can sell "time" without utilizing the put option to again earn premium on a stock that otherwise has traded down from $96.54 (purchase price) to $91.43 (today's close). Through the use of covered calls we have managed the cost basis down to $80.84 and will simply continue to roll. I recommend selling the Jan 12 $95 call for $4.70 and review again at that time.
Keep in mind that "Time" doesn't always have to "punish (us)" if we are on the correct side of selling time.
Accept delivery of GCI shares at $15 share from Oct 11 $15 put.
Sell to open GCI Jan 12 $11 call (GCI120121C00011000) at the market Friday, October 21, 2011.
Accept delivery of MIPS shares at $9 share from Oct 11 $9 put.
Sell to open SNP Jan 12 $95 call (SNP120121C00095000) at the market Friday, October 21, 2011.
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