Having recently taken an interest in what is called a bull call spread, I was intrigued when I noticed a very large options play that was entered into by a player in Sirius XM (NASDAQ:SIRI) on Friday, June 7th. The play yields a $5.50 share price return, or 58% over Sirius XM's current $3.50 share price, once Sirius XM reaches $4.50 per share.
The Fundamental Story
Before getting into the nitty gritty of the options play, though, it's important to understand Sirius XM's fundamental story and my expected price target for the end of 2014 / early 2015.
There are two critical issues at play here which allow me to arrive at my $5 price target for the end of 2014 for Sirius XM.
The first, is Sirius XM's stated $2 billion share repurchase program which is already underway.
Because of this, I expected that the share price of Sirius XM would have strong support and would find a stair stepping pattern of appreciation with rising support during periods of consolidation followed by pops once the share price was squeezed enough. It's similar to the type of behavior seen as Liberty Media (NASDAQ:LMCA) was buying shares for control. Supply dwindles as shares are bought, and the buyer must move the share price up to acquire more shares.
Has this happened? Yes. Arguably it has. When you consider the 1 year chart of Sirius XM a sort of stair step pattern of appreciation is readily apparent.
Up, over, up, over, up, over. It should be clear to see. That green line there? That's support, and what I have been stressing is a good indicator of a strong buy area at or below it.
This program had already repurchased 209 million shares as of Sirius XM's Q1 call, and there is little reason to expect that it has not continued since. By removing shares outstanding, each remaining share is worth more, and this slowly lifts the share price of Sirius XM over time. Think of it as a rising tide lifting a boat. Sure the waves (volatility of the market) bounce the boat up and down short term, but as that tide slowly comes in, the boat rises higher and sinks less relative to where it was before.
For May the auto sales pace appears to be back on track. It is anticipated that the sales tally for the month will be in the neighborhood of 1.4 million units, well above the 1.1 million level that allows Sirius XM to report good metrics.
It is anticipated that for the full year, new car sales can approach 15.5 million units. Sirius XM delivered over 2 million net subscriber additions in 2012 on new car sales of 14.5 million. For 2013 the guidance is 1.4 million net additions on a new car sales market of an anticipated 15 million.
and with used autos increasingly penetrated by Sirius XM's installed base of receivers :
At the moment Sirius XM has over 9,000 used car dealerships signed up for participation in the free trial program. Industry data reveals some very interesting information about the secondary market:
- There are approximately 18,000 franchised auto dealerships that sell both new and used cars. Essentially, Sirius XM has a relationship with well over half of them.
- Last year approximately 13 million used cars between 0 and 6 years old were sold. Sirius XM was installed in 33% of new cars in 2007 and is now installed in about 67% of new cars. Between 2007 and 2012 new car sales stood at 78.5 million with 42.7 million of those cars being satellite radio equipped. It would appear that 65 million cars from that group remain with their original owners while some 13 million have been sold in the secondary channel. Essentially, 54% of these cars have satellite radio. This number will grow.
the potential market for new subscribers is always increasing. Sirius XM's expansion of deals with the used auto sector only serves to help maximize exposure in this market and should help continue to grow subscribers.
These two fundamental parts are critical to Sirius XM's bullish story going forward, and likely weigh heavily on the options play I am about to outline, and the sentiment of the player.
A bull call spread is an net debit options play entered into by purchasing one lower strike (usually at the money) call and writing a higher strike out of the money call. In doing so the option player hedges his or her bet, limiting both losses and gains for a net debit position. The options industry council defines a bull call spread as the following :
A bull call spread is a type of vertical spread. It contains two calls with the same expiration but different strikes. The strike price of the short call is higher than the strike of the long call, which means this strategy will always require an initial outlay (debit). The short call's main purpose is to help pay for the long call's upfront cost.
Up to a certain stock price, the bull call spread works a lot like its long call component would as a standalone strategy. However, unlike with a plain long call, the upside potential is capped. That is part of the tradeoff; the short call premium mitigates the overall cost of the strategy but also sets a ceiling on the profits.
The play entered into on June 7th can be shown in the following images. Take a look at the options volume and trade times for the January 2015 LEAPs at the $3.50 and $4.50 strike prices.
Now you might notice here that the player sold twice as many $4.50 calls as the number of $3.50 calls they purchased. So this play is more complex than a simple bull call spread, and an assumption is in order that there is one more underlying hedge to complete this strategy.
The player is likely also "long" the stock, and while 20,000 options make up the bull put spread, the additional 20,000 $4.50 calls would have been sold to "cover" the owner's long position.
The Results? Brilliant.
By being long the underlying shares, and by receiving $1,360,000 credit for the written calls and paying just $1,380,000 for the purchased calls, this entire "play" costs the long stock holder a net debit of only $20,000. Small change when considering that the player's underlying stock position was worth $7,000,000 on 2,000,000 shares at $3.50 each at the time. The cost to enter this play was 0.3% of the total position's value.
By taking a look at the results of the "total" play compared to all the parts in the following graph it should be easy to see why this is such a brilliant move.
So what are you looking at here?
The most simple graph here is in red. That's a profit and loss graph from owning the 2,000,000 underlying shares at $3.50. Most people should be very familiar with this straight line.
The two plays which make up the complex strategy I have called "brilliant" above are in green and yellow.
The yellow line is the simplest of option strategies, or the covered call. Long the stock at $3.50 covered with a $4.50 January 2015 covered call. Notice the additional profit, lower downside breakeven point, and $4.50 inflection point for capped gains.
The green line is the bull call spread. The net debit outlay results in a maximum loss at the lower strike, or $3.50, and maximum profit at the higher strike, or $4.50.
The key here is the blue line. That's the "play" above, and it is a result of the addition of the yellow and green graphs due to the combination of both the bull call spread and the covered call position. Notice below the $3.50 mark the "play" turns into the same line as the simple long stock position in red, but above this the play slopes up rapidly, resulting in double the gains until the $4.50 mark at which gains are capped. It is not until a $5.50 share price that the gains of the simple long stock position exceed the gains of play denoted in blue.
Keep It Simple
The overall strategy effectively yields twice the rate of gains and gives the player the return normally received by a $5.50 share price at a $4.50 share price for an additional minimal cost of 0.3% over a simple long stock position. The "risk" is merely a possibility of lost future gains above a $5.50 share price at expiration in January of 2015, but until that point the play as discussed yields greater return.
How does one enter this play? Timing is crucial, and the best prices will be found when the share price of Sirius XM is at or near $3.50 per share if you are already long the stock. If you currently hold no position in Sirius XM, timing will not be as important, and entering the play below a $3.50 share price should be attractive. You will also need to be approved for options and for trading spreads (level 3 options trading through E*trade).
If you are long the stock
- Sell 1 $4.50 January 2015 call for each 100 shares you own. This establishes a covered call position.
- Simultaneously buy a January 2015 $3.50 call and sell a January 2015 $4.50 call for each 100 shares you own. This establishes a bull call spread.
If you currently have no position in Sirius XM
- Perform a "buy write," simultaneously selling 1 $4.50 January 2015 call for each 100 shares of stock purchased. This establishes your covered call position.
- Simultaneously buy a January 2015 $3.50 call and sell a January 2015 $4.50 call for each 100 shares you purchased. This establishes your bull call spread.
I view this play as a very low risk, high reward play compared to being long the stock based on my fundamental assumptions for Sirius XM through January 2015. With a $5 price target on the stock for the end of 2014, this play should yield greater returns than a simple long stock position and those returns should be reached more quickly, at a share price of $4.50 per share. A 57% return is realized with only a 28.5% increase in share price, and the only risk is the forfeiture of gains beyond $5.50 and the very small premium of 0.3% paid to enter the position.
This play may not appeal to you if you see pricing beyond $5.50 per share in 2014, but 57% return over 18 months? In my opinion that's excellent. For those who hold opinion similar to mine on Sirius XM's fundamental story, and thus hold a similar price target, this play results in high reward for minimal additional risk.
Additional disclosure: I am long SIRI January 2014 $2, $2.50 and $3 calls.