AEP: Using Options to Outperform the Broad Market

| About: American Electric (AEP)

In an article I wrote about American Electrical Power Company (NYSE:AEP) last February, I felt that AEP was unloved and underrated. To quickly rehash, I wrote about two specific investment strategies for it. I was bullish on AEP at $35.28 and it currently has closed at $37.58 or a return of $2.30 or 6.5% in less than three months. Not too shabby, especially when one considers how safe a utility trade can be and how it handily outperformed the S&P 500. During the same period the SPY has returned $1.47 or 1.10%. Using SPY as a proxy, AEP has roughly outperformed the broad market index by 5.4% in three months.

I still feel there is some upside in AEP, but at this juncture I have taken profits and have no existing positions. I would recommend that those who followed my article and implemented a similiar structure take profits in some manner, and I will suggest a few.

The trade I favored most was selling the January 2012 $30 puts for $1.00 and buying the January 2012 $35 calls for $2.00. The net margin requirement used was roughly $500 to cover the margin requirements for the short put components. As of Friday's market close the $30 puts had an ask price of $0.50 and the $35 calls had a bid of $3.30. This structure yielded a profit of $1.80 per leg or $180 per leg against the $500 in margin requirements, or a 3 month return of 36% off a 6.5% return in the stock.

I would have to say -- 36% return in less than 3 months in a utility stock in the current climate is pretty good. There could have been a bit more optimal trades, but they carried higher amounts of risk.

The other trade I recommended was a regular covered call trade, selling $40 calls in January 2012 for $0.35 and buying the stock at $35.28. The reason I did not favor this trade was the higher margin requirements ($3,493). In a true case of irony, and given the timing of the trade currently, the covered call trade has yielded a profit of $1.80 as well or a 5.15% return (not counting dividend).

As you may recall, the maximum value at risk on the risk reversal was $3,100 ($31 cost per share if assigned on the short $30 puts) versus the $3,493. So the trade that carried less risk also outperformed the more risky trade by 30.85%. This is why I love options and believe everyone should learn to use options properly to enhance risk / reward functions.

Moving on to the real heart of the matter-- what is the best thing to do now? Given the two outcomes listed above on my trades, one could close them out, book the profits and call it a day. Perhaps hope for a broad market pullback or a pullback in AEP-- it could happen. However, my favorite strategies always involve having a very nicely profitable trade and taking out all of my original capital and risk, and some profits (we all gotta get paid), while leaving a lottery ticket position.

However the only strategy that is really available would have been on the risk reversal ($30 put short and $35 calls long).

My thoughts are pretty simple trading to get rid of my original capital and risk in the trade, as well as pulling profits out of the trade. Close out the $30 puts and book $0.50 of profits, sell the $35 calls and book $1.30 in profits and invest / gamble / bet $0.85 of those profits and buy the January 2012 $40 calls. You end up collecting $0.95 in profits that cannot be lost, but get that lottery ticket upside.

As said above, I no longer have any positions in AEP and the reasoning behind that is twofold. I am hoping there is a pullback in AEP, or that there is a broad enough market pullback that it also drags AEP down (or another name I like), so I can deploy the capital.

Ultimately, I am building a whole lot of cash in the hope that we get some volatility and not just a slow grind upwards.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Tagged: , , Electric Utilities, Options
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