The REIT sector as a whole currently presents several compelling opportunities to go long. Options strategies allow an investor to take advantage of such opportunities by utilizing leverage to maximize gains while requiring a smaller initial cash outlay to establish the position. At this point in time, Newcastle Investment Corp (NYSE:NCT) is displaying some numbers that indicate we may be at an entry point for a six-month options play. For some additional information and analysis specifically on Newcastle's operations, you can read articles here and here.
For the past year, the stock has continued an upward trend reflecting the improvement since the housing bubble and mark-to-market accounting issues in 2008-2009. Additionally, there is plenty of discussion how changes in the tax code are expected to change investor behavior in regards to selecting stocks that pay a dividend as opposed to a distribution. The question essentially centers upon tax rates of each type of income. If dividends become taxed at the same rate as distributions, investors will have little remaining incentive to choose dividends over distributions as the net return would be the same. REIT yields are generally higher than dividends, which could theoretically drive prices higher in return. Granted, no financial discussion is ever that simple, but this does lead to some interesting potential mid-term investments.
I'll do the math as if there is no fee, so remember to adjust these examples to reflect whatever you must pay through your brokerage. And also remember that options work by using leverage -- a small move in the stock price can result in a significant move in the price of the option. Although this can result in very nice returns on a percentage basis, a small move the opposite direction can eliminate you entire investment in a matter of minutes. Do your homework.
The first and most obvious opportunity with this stock is to use the May 2013 $10 call to generate additional income off shares you already own. If you do not already own shares, you can buy them for $8.21 and reduce your cost basis by 20 cents using this strategy. If the stock does break out and breach $10 by May, you will realize a 24% profit in five months (58% on an annual basis). If the stock is stagnant or drops during this period, you can let the option expire while keeping the premium and just continue to collect the dividend on your shares. The downside scenario would involve the stock making a significant move in either direction. By selling the covered call, we limited our profit to the 24% discussed above. Should the stock move downward below our adjusted cost basis, we also stand to lose whatever the stock drops beyond that. However, while the extreme scenarios are possible, they are not as likely as the stock finishing somewhere between $7 and $9.
A second obvious opportunity is to purchase the $7.50 calls for May 2013. At the current ask of $1.10, the stock needs to break $8.60 (a 4.7% move) for the trade to break even. At that point the trade becomes profitable, and you should consider setting a stop so that if the trade does move into the profitable range you pocket a profit if things turn around. Granted, the mean analyst 12-month target for the stock is currently sitting at $8.80, but at that price with no time value the profit would be in the 18% range -- not bad for five months. Any remaining time value would add to the profit and you should consider locking in a win.
An additional consideration is that the theoretical value on this contract is currently $1.30, so you could simply purchase the option with the intention of selling it if/when actual value reflects the theoretical value. The theoretical value is currently 18% higher than the actual value.
Bull Call Spread
This trade would consist of purchasing and selling an equal number of contracts at different prices.
For example, buying the May 2013 calls at $7.50 for $1.10 and selling the $10 call for $.20 results in a net cost of $.90 per contract. As the time value decreases, this trade remains profitable at any point over $8.40 (a 2.3% increase in the stock price). However, should the stock move above $10, your profit reaches the limit of $1.60 per trade. The maximum loss of $.90 would occur if the stock closes below $7.50.
Other spreads can be built using different strike prices, but the key will be to find one which minimizes the cash required to build the position while maximizing the potential for an acceptable gain.
No strategy is guaranteed to make money all the time. However, looking for opportunities where it makes sense to enhance your portfolio strategically with options can pay off significantly on a percentage basis. I currently believe that Newcastle's stock will at least remain stable over the next six months if not continue a slow uptrend. If you couple this with options trading at prices which have a small time value associated with them, there is an opportunity to make a smaller investment with the potential for a larger profit.
These types of trades can be built with any company that displays stability or a probable future uptrend. In this case, Newcastle is displaying fundamentals that support the current price with an acceptable level of risk, and the time value on the options is relatively small with respect to the amount of time remaining.
Again, anyone considering these trades would need to confirm the calculations and adjust them for brokerage fees. And never put more money into an options trade than you can handle losing in the next five minutes. Good luck out there!
Disclosure: I am long NCT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.