Philip Morris International, Inc. (NYSE:PM) has shed over 12% from its October highs and is now trading in the oversold ranges. If you look at a long-term chart, you will notice that historically any pullback in excess of 10% has proven to be a buying opportunity. However, it never hurts to have a hedge in place just in case things do not go according to plan. A bull put spread is a conservative option based strategy that limits your downside risk but also provides you with the opportunity to lock in decent returns if the shares are not put to your account. You simultaneously sell one out of the money put and purchase one put that is farther out of the money for a net credit. The maximum gain is achieved if the stock trades at or above the highest strike price. Your total risk is equivalent to the spread between the two strike prices. This would only occur if the stock closed at or below the lower strike price.
Benefits of a Bull Put Spread
- It limits your losses if the stock suddenly plunges. Your loss is limited to the total differences between the strike prices of your short put (the put you sold) and long put (the put you purchased).
- The ability to profit even if the stock barely budges in price.
- The risk is significantly lower than writing a naked put as your maximum downside is limited by the put option you purchased. For example, if you sold a put on Merck & Co. Inc. (NYSE:MRK) with a strike at 45, and the stock dropped to zero, your loss would be $4500 minus the premium you received. Now if you purchased a put with strike at $40.00, your maximum loss would be $500 minus the net premium you received. The difference is rather significant.
- The capital requirements are considerably less. With a cash secured put you would need to have enough cash in your account to back the sale of the put. If you sold a put with a strike at $45, you would need to have $4500 in the account. With the bull put spread, your capital requirement is limited to the spread between the two strike prices. In the above example, the spread is $500. This is significantly less than the $4500 you would have to put up if you sold a cash secured put on Merck with a strike at 45. This strategy should not be abused just because the capital requirements are significantly less.
- In the event the stock declines, an investor can buy to close the short put position and continue to lock in gains from the long put as the price of the underlying stock drops.
Points of interest
- A very strong healthy levered free cash flow of $7.3 billion
- A good yield of 4.00%
- Zacks has a projected 3-5 year EPS growth rate of 9.3%
- A three year dividend growth rate of 12%
- A manageable payout ratio of 63%
- A three total return of 80%
- A very healthy profit margin of 27%
- A strong interest coverage ratio of 15.00
- $100k Invested 6 years ago would have grown to $185K.
- Net income, cash flow per share and sales has been trending upwards for the past three years.
- The quarterly dividend was raised by 10.4% to an annualized rate of $3.40 per common share.
- The company repurchased 16.7 million shares at cost of $1.5 billion in the 3rd quarter. It completed its three share repurchase program worth $12 billion ahead of schedule in July 2012 and has now commenced a new three year share buyback program of $18 billion.
The stock was rather overbought when it was trading above $90 and the current pullback has made the stock more attractive from a long term perspective. It has a decent amount of support in the $79.00-$80.00 ranges. A second and much stronger level of support comes into play in the $74.00-$75.00 ranges and should serve as a floor to lower prices in the short to intermediate time frames. Consider waiting for it to test the $79.00-$80.00 ranges before putting this strategy to play. As long as the stock does not close below $70.50 on a weekly basis, the outlook will remain neutral. A weekly close above $85.00 would turn the outlook to bullish and indicate that the stock was ready to test the $90-$91.00 ranges.
It will be compared against its competitors using several key rations such as quarterly revenue growth, P/E, EBITDA, Operating margin, PEG, etc. If you feel that competitor would make for a better investment, you could utilize a similar strategy.
M= Million B= Billion
Charts of value
The blue shaded area represents the dividends. The orange line represents the valuation growth rate line. Generally, when the stock is trading below this line and in the shaded green area, it represents a good long-term entry point. The stock is currently trading slightly above this line, so the current correction could push it below this line, which should make for a good long term entry point. According to fast graphs, it has an estimated earnings growth rate of 10.1%
When a stock is trading above the EPS and EPS consensus estimate line, it is a bullish phase, and the outlook is for higher prices. The stock is trading well above the EPS consensus line. According to this relationship, strong pullbacks should be viewed as buying opportunities.
Philip Morris has clearly clobbered the competition in terms of ROE. The closest competitor ironically is Altria.
Bull Put Spread
Both parts of this transaction need to be implemented simultaneously.
The March 2013, 80 put is trading in the $2.35-$2.40 ranges. If the stock pulls back to the stated ranges, the put should trade in the $3.80-$4.000 ranges. We will assume that the put can be sold at $3.80 or better.
The March 2013, 75 puts are trading in the $1.16-$1.22 ranges. If the stock pulls back to the stated ranges the put should trade in the $1.80-$2.00 ranges. We will assume that this put can be purchased at $1.90 or better.
- After the sale and purchase of the respective puts you will have a net credit of $190.00.
- Your maximum risk is $310 (the spread of $500 is subtracted from the credit of $190).
- Your maximum profit is $190 per spread for a possible return of 61%
- Your breakeven point is $78.10
Strategy to boost your returns
One method of boosting your gains would be to purchase a put with less time on it, while selling one with more time on it. The risk of this strategy is that while you boost your gains as a result of having to put up less money, you also raise your risk. Your position will only be hedged for a limited time. Once the put you purchased (lower strike) expires, you will effectively be selling a naked put and your margin requirements could rise unless you purchase another put. If you opt for this strategy, then you should consider either buying a new put or closing the position out when the put you originally purchased expires.
Risks associated with this strategy
The main risk is that you over leverage yourself because the capital requirements are so small. There is always the chance that the shares could be assigned to your account if the stock is trading below the strike price of the option you sold. If the shares are put to your account, you could always turn around and sell them, provided you had the funds in place to cover the initial purchase.
The net credit you get from the trade is usually much smaller than the maximum amount of money you could lose from the trade. Consider rolling the short option or closing the spread out before your position hits the maximum loss point. Professionals generally take this route when the short option is at or slightly in the money. To roll the short put, you would simply purchase the original put you sold and sell a new out of the money put. If you close the spread out, you can always write a new one.
Do not abuse this strategy as the long put does not prevent the shares from being assigned to your account. The bull put spread limits your total loss to $380, but it provides you with the chance to lock in up to 61% in gains in roughly 4 months. This is a conservative strategy, and if you abuse it, you will have converted it from a conservative strategy to a speculative one.
Options tables and competitors data sourced from yahoofinance.com. Option profit loss tables sourced from poweropt.com. ROE and EPS charts sourced from zacks.com.
It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was prepared for Tactical Investor by one of our analysts. We have not received any compensation for expressing the recommendations in this article. We have no business relationships with any of the companies mentioned in this article.