Bullish reversals (short puts, long calls at a higher strike, bracketing the share price) may be attractive right now. I usually give a little thought to possible situations ahead of earnings, and this quarter a number of cases where I have used the strategy profitably in the past are lined up in ways that suggest a repeat is in order. This article discusses some general ideas I use when considering the strategy, and goes on to present a number of trades that I will be looking to execute during the coming week.
The stocks selected are from the Electronics Components and Electronics Manufacturing Services industries. Earnings have been increasing nicely during the economic recovery, but recent share prices reflect pessimism, perhaps unwarranted.
When to use – because the strategy involves the sale of puts, the investor/speculator should first verify that he is willing and preferably eager to buy shares at the put strike. Stocks trading in the vicinity of tangible book value per share, or where a chart suggests they are at or near a strong support level, make sense to me.
High beta or volatility helps. Ideally, the stock should have a tendency to gap up and down, perhaps on earnings, be subject to possible acquisition or rumor thereof, or be likely to post an earnings surprise. These are not necessarily grade A number #1 stocks – just high beta cases with good if uncertain prospects.
There should be a plausible if remote possibility of a valuation substantially in excess of what the market offers. Because options pricing theory assumes the current price is correct and then distributes future probabilities in a uniform way, out of the money calls are sometimes under-priced when outsize moves are possible. A recent history of trading above the strike on the call is a big plus.
The initial cash outlay should be low, a net credit or possibly a small debit, such that the sale of the puts funds the purchase of the calls. When possible, I like to do this on a ratio, with more calls than puts.
I prefer expirations out 60-90 days or more if possible. That way, the stock does not necessarily have to be above the strike on the call at expiration: it may be possible to close the position at a good profit before expiration if the underlying makes a strong upward move.
Trades under consideration – the following is a list of the trades I am looking at for the coming week. The bid/ask shown is as of Friday's close.
- Sell to open 10 VSH Oct 16 2010 7.5 puts @ .80/.85
- Buy to open 40 VSH Oct 16 2010 10 calls @ .10/.20
- Sell to open 10 JBL Dec 18 2010 12.5 puts @ 1.15/1.25
- Buy to open 10 JBL Dec 18 2010 16 calls @ .95/1.00
- Sell to open 10 FLEX Oct 16 2010 5 puts @ .20/.22
- Buy to open 10 FLEX Oct 16 2010 7.5 calls @ .13/.14
Vishay Intertechnology (NYSE:VSH) – closed Friday at 7.54. I wrote this up favorably last week with a target of 14, and have now come around to the belief that earnings are going come in above consensus. The current price is in the neighborhood of tangible book value, the company is making money, and shares traded above 10 for several months recently, hitting a 52 week high of 11.33. Beta is 2.1; iVol 62.9%. This strategy has worked 2 out of 3 times I used it in the past on this company. The third time was late 2008; I was assigned on some 10 puts, enlarged the position substantially at the March 2009 bottom, and emerged with a fine profit.
The 4 to 1 ratio will result in a very good payoff if the position develops favorably.
Jabil Circuits (NYSE:JBL) – closed Friday at 13.97. I have written the company and the strategy up previously, and this is another case where I have had success on several occasions. While confessing some embarrassment at the time, I did mention a target in the 17-27 area, and the shares have since notched a 52 week high of 18.49. Looking at a chart, this has been above 16 quite a bit lately and looks to have some support around 12. The last earnings report was a beat.
One way to figure the odds on the strategy is to count how many days out of the past year the stock has spent in the three price bands involved. Here is a simple bar chart:
Flextronics (NASDAQ:FLEX) – closed Friday at 6.07. Same industry as Jabil: I saw a target of 11 when I wrote it up in January. S&P shares my views; Morningstar is quite negative. The heavy debt load is of less concern as Fitch recently upgraded them from BB+ to BBB- with a stable outlook. Eyeballing a chart, this hasn't spent too much time under 5 during the past year, and has been above 7.50 as recently as March and April.
This is another one where the barchart can be used to show the odds:
Final thoughts – this is a speculative strategy, intended to achieve quick profits with a modest cash outlay, or even a net credit to open. With the market down as much as it is, and earnings expected to be strong, a lot of things could happen. It's like buying a lottery ticket, the difference being it may be possible to do so under conditions where the odds are in the investor/speculator's favor. A few of these from time to time livens up a portfolio. It pays to pick your spots.
Disclosure: Author is long VSH and FLEX and intends to execute the trades described during the coming week