Over the last year or so, I've run into a dilema.
Both the Magic Formula and MagicDiligence screens rank stocks on a relative basis. These screens show us which stocks in the market have the best combination of business quality (measured by return on capital) and cheap price (measured by earnings yield).
The one issue with a relative screen is that the market is the tide that lifts all ships. Just because a stock is cheap relative to the market, does not necessarily mean it is cheap relative to its own business prospects or valuation history.
I like to buy Magic-style stocks at a significant margin of safety to a reasonable fair value calculation. For much of the past year or so, finding acceptable margins of safety has been a challenge.
Most of the time, this would just lead me to pass on a stock at that moment.
But today, I want to share a strategy that is used by sophisticated money managers to profit from stocks they wouldn't mind owning but are not yet at a margin of safety they are comfortable buying outright.
Don't Let Options Scare You
To do this, we are going to dip our toes into the world of stock options. Since this is a topic many may not be familiar or necessarily comfortable with, let's do a quick primer.
Stock options are contracts which give you the right to buy (call option) or sell (put option) a given underlying stock, at a given price, on a given date. Each contract is typically for 100 shares of the underlying stock, so to calculate the cost of 1 contract, you normally multiply the quote times 100 (e.g., $0.40 contract costs $40).
Each stock option has 3 important parameters. One is the "strike price", which is the price at which you have the right to buy or sell the underlying stock. Two is the "expiration date", the date on which the contract goes into effect. And 3, of course, is whether the option is a call or put.
On the expiration date, one of two things can happen:
1) For a call, if the stock price is above the strike price, you get to buy 100 shares at a price lower than the current trade. For a put, if the stock price is below the strike, you get to sell 100 shares at a price higher than the current trade.
2) In the opposite scenarios, the options expire worthless and nothing happens.
So that is options in a nutshell. To make money on stocks that are not quite cheap enough to buy, we can utilize the put option in a creative way.
Selling Puts for Fun and Profit
The basic strategy here is to SELL (not buy) put options at a price we would be comfortable buying the underlying stock at. By selling puts, we collect a payment upfront, making some cash without buying anything.
At the expiration date, there are two potential outcomes:
1) The stock trades above the option strike price. In this case, the put option expires worthless and we've kept the upfront payment without buying a thing.
2) The stock trades below the option strike price. In this case, we are compelled to purchase shares of the underlying stock at the strike price minus the price of the put option.
We'll go through an example below. The beauty of the strategy is that either outcome should be acceptable to us, if we like the underlying stock at the strike price.
An Attractive Current Example: Symantec (SYMC, Financial)
Security software firm Symantec (SYMC) is a stable, relatively predictable company. Switching costs are high, and Symantec's entrenched position have led to predictable revenue and operating margins over a long period of time.
Recently, though, some management turmoil has caused the stock to trade in a more volatile manner than its business profile would suggest. The current quote of $20.60 is meaningfully below most analyst's price targets, and almost 25% below our target (SYMC is one of our current Top Buy picks).
However, we'd like to get a little more margin of safety before buying - our buy target is $20.
So, let's take a look at Symantec's $20 put option expiring on May 17. The last price for this option was $0.47. Let's walk through the trade:
1) We are willing to buy $10,000 worth of SYMC at $20. That's 500 shares. Since each options contract is worth 100 shares of the underlying stock, we'd be selling 5 contracts. Our immediate income would be ( (0.47 * 100) * 5) = $235, and we would have to lock up $10,000 in cash.
2a) If SYMC trades over $20 on May 17th, we keep the $235 and the $10,000 is freed up. End of trade!
2b) If SYMC trades under $20 on May 17th, we will automatically buy 500 shares at $20. HOWEVER, since we already made $0.47 per share, our actual cost basis is $19.53 per share.
Either way, we've done okay. In case (a), we've earned a 2.35% return on our $10,000 ($235 / $10,000) in one month, which annualizes to over 28% (2.35 * 12)! In case (b), we've purchased shares at a price below where we are comfortable with.
Not bad!
The Risks
Like any endeavor in the stock market, there are a few risks to consider:
1) The stock appreciates more than the cost of the option up to the expiration date. This is more of an opportunity cost. It would have been better to just purchase the stock.
2) Some occurrence before the expiration date causes the stock price to tank well below the strike price. In this situation, we are forced to buy at a price well above market. This is the biggest risk in my opinion. That's why this strategy should only be used for relatively stable companies and at a strike price that already builds in a nice margin of safety.
In a lot of ways though, the selling puts strategy is less risky than a straight purchase. Consider that risk #2 also applies to any outright purchase of a stock, and for risk #1 you are still making money.
Conclusion
Selling puts can be a nice way to make some money even on stocks that are not yet cheap enough to purchase outright. In the current fairly valued market, it is another option for investors to make some money while waiting for stock prices to retreat - or not - to more attractive valuations.
