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Since Travelers Insurance (NYSE:TRV) released disappointing earnings for Q2 July 22, the market has continued to punish the stock. Prior to the release Travelers’ stock had been trading in the $58 range, but since the release the stock has steadily traded lower. Currently it is trading in the $54 - $55 range.

Travelers’ has been under pressure from not only their disappointing earnings release but also the prospect that the U.S. might default on debt obligations. Travelers has a large portion of its investment portfolio in municipal debt, according to the filing June 30, it owed $39 billion worth of it. If the U.S. were to default on the debt the immediate downgrade and rise in interest rates that would follow could negatively impact Travelers’ portfolio.

With the prospect of default off the table I think it is time to start focusing on the fundamentals of Travelers. There is no getting around the fact that Travelers posted a $364 million dollar loss. The last time that Travelers posted a quarterly loss was back in 2005 during the aftermath of hurricanes Katrina and Rita. Similar to 2005 this quarter’s loss was also due to several unforeseen natural disasters.

Even with all of the losses from the disasters this spring Travelers was still able to have some positives come out of Q2. Travelers’ policy sales climbed 2.3% to $5.82 billion. The unrealized investment gain net of taxes increased by $400 million, to end the quarter at $2.2 billion. Travelers continued to follow through on its share repurchase program; year-to-date Travelers has repurchased 1.3 billion in stock. Travelers ended the quarter with a book value of $59.62/share. Book value is the price that the stock would be valued at if all assets were sold off, all liabilities paid for, and the remainder (Stockholders Equity) was distributed amongst the shareholders.

There are several ways to take advantage of this oversold situation. You can purchase the stock at $54-$55/share and hold. This is not a bad strategy considering Travelers’ book value is currently at $59.62. In oversold situations like these I prefer to take advantage of the high volatility in the stock that has been created and sell puts on the stock at strike prices that I would consider a good entry price. Based on the historical chart there seems to be a fair amount of support at the $50 level. I would consider buying the stock there. Since the stock is not currently at that level I would suggest selling puts at the $50 strike for January 2012. I like January because with all of the recent volatility in the stock price the options are nicely priced and the far out contracts give you plenty of time to be right on your position.

(Click chart to enlarge)

Selling naked puts does involve some risk, but if managed appropriately it can provide a nice return and allow the investor the ability to pick an entry point (via the strike price). Selling puts at the $50 strike price obligates you to purchase the stock at that price for the equivalent number of put option contracts that were sold (1 contract = 100 shares of stock). Selling puts at that level also gives the seller a buffer of almost 10% from the current market price of the stock. At expiration of the option contract if Travelers is at or below $50 the seller will be obligated to buy shares at that price. If this happens the seller is still able to keep the premium that was received for selling the puts originally. This premium will further help defer the cost of buying the stock. If the stock price is above your strike price at expiration the contracts expire worthless and the seller gets to keep the premium received originally for selling the puts. Currently the January 2012 $50 puts are trading for $1.80/share ($180 per put contract).

The biggest benefit of selling put contracts is that it allows the investor to pick the entry point and wait for the stock to come to him or her. If that never happens the investor still got paid to wait. This strategy has two different outcomes, both in my opinion are favorable for someone who wants to invest in Travelers.

  • The stock increases in value between now and January 20, 2012. Your options at the $50 strike expire worthless and you keep the premium you collected for doing the trade.
  • The stock continues to fall and goes below $50/share between now and January 20, 2011. If this happens you would be obligated to buy 100 shares of stock per contract sold of Travelers at the $50 strike.

Looking at Travelers from a pure fundamental basis (excluding the one-time tornado payouts), I feel the company deserves a second look and should be considered a ‘buy’ at its current price level. I see no good reason why Travelers will not continue to deliver solid returns to shareholders and exceed expectations in the second half of the year. The market on the other hand is pricing Travelers on the expectation that it will continue to miss quarterly earnings going forward. This mispricing provides investors with an excellent opportunity to capitalize on what I believe to be an extremely oversold situation. Bottom line, catastrophic natural disasters happen every now and again, but they don’t happen every quarter, regardless of what the market might think.

Source: Using Put Options to Profit on Travelers Insurance