Using Cash-Secured Puts on Cash-Rich Companies To Play Volatile Markets

by: Vince Martin

I've written two previous articles (here and here) on selling cash-secured puts on cash-rich stocks, and here are the final three currently on my screen.

To repeat the underlying thesis, by selling out-of-the-money puts at strike prices closer to the company's cash balance, we achieve one of the following outcomes:

  1. We retain the premium (or a portion thereof) on the sold put as a return on risk capital.

  2. We purchase the stock at a level nearer to its cash per share balance, at a substantial discount to current prices on an enterprise value basis.

Please note that investors must secure the puts with cash equal to the risk capital (defined as the strike price minus the premium x 100 x the number of contracts). If you sell 1 XYZ 10 put for $1.00, you should have $900 in the account. In such a volatile market, writing naked puts can leave you vulnerable to punishing margin calls, as naked puts offer maximum gains that are a fraction of maximum losses (in our XYZ example, maximum gain is $100, while maximum loss is $900).

Remember: This is not necessarily an option trading strategy, but rather a hedged way to play stocks that we would consider buying at current prices, and would be happy to buy at the downside price. Please remember that these options may have large spreads and light volumes, so always use limit orders and be prepared to accept delivery of the stock should the sold puts be exercised.

  1. MIPS Technologies (NASDAQ:MIPS)

Closing Price 8/19: $4.89

MIPS has bounced off an 18-month low, after fiscal fourth quarter earnings in early August missed analysts' expectations badly, and a drop in revenues caused fears about the company's future earnings power. The stock touched $18 in February before beginning its steady decline.

MIPS' main business is designing processors for consumer electronics. In 2010, it announced plans to enter the smartphone market as well, with its initial focus on Google' s (NASDAQ:GOOG) Android phones. In January, ABI Research projected that by 2016, the company would split 18% of market share with Intel (NASDAQ:INTC), in a market expected to sell 700 million units. While weak results in the second half of 2011 may diminish those expectations, MIPS retains an excellent product with exposure to a growing market (and, in Android, the fastest-growing platform in that market).

MIPS did manage to generate about $21MM in free cash flow in fiscal 2011 (this is an estimate based on the change in cash balance quarter-over-quarter, as the company has not released its most recent 10-Q containing the cash flow statement), roughly 17% of enterprise value. The balance sheet is strong, as it has $1.98 per share in cash net of liabilities, about 40% of market capitalization.

Short-term, more aggressive traders can sell the September 4 put bid at .20 (ask .30). This provides a 5.2% return on a 4-week trade, or 68% annualized. Our downside price into the stock is $3.80, a 12% decline, 22.2% on an enterprise basis.

Further out, the January 4 put is bid at 60 cents (ask .70), offering more downside protection, albeit on a longer trade. Our return here is 17.6% (41.7% annualized), with a downside price of $3.40, a 21.2% drop from current levels. More conservatively, the January 3 put is bid at 20 cents, a 7.1% return on risk capital (16.8% annualized). Breakeven for this trade is at $2.80, a 35% drop in the underlying (in only 22 weeks), requiring a drop in enterprise value of 65%.

  1. eHealth (NASDAQ:EHTH)

Closing Price 8/19: $12.58

eHealth is an Internet-based insurance agency, specializing in health insurance for individuals and small businesses. The company has $6.35 in net cash per share -- just over half of its market capitalization -- and while its 2011 guidance for earnings is only in the range of 31 to 40 cents, its cash flow numbers are more impressive. eHealth has generated $9.5MM in free cash flow in the first half of the year, about 14% of enterprise value on an annualized basis.

eHealth's core business has been steady if unspectacular, and solidly profitable the last four years (Annual FCF from 2007-2010 in millions of USD: 24, 28, 27, 15). With the growth of state-run exchanges for uninsured citizens, and the coverage mandate enshrined in the 2010 health care law, eHealth's agency business should have the opportunity to expand.

There are sizable spreads in eHealth options, so be sure to use limit orders. At the bid, short-term traders can sell the September 12.5 put for 50 cents. This is a 4.2% return on a 4-week trade, or 54% annualized. Downside is owning eHealth at $12.00, 4.6% off current levels.

The February 12.5 put is bid at $1.30 (ask $1.75), providing an 11.6% return on a 26-week trade (23% annualized). Downside is owning eHealth at $11.20, 11% off current levels (a 23% drop on an enterprise basis). Lower put strikes of 7.5 and 10 are available at the February expiration, but have little or no open interest and even larger spreads.

  1. Insperity, Inc. (NYSE:NSP)

Closing Price 8/19: $23.54

The personnel management company -- known as Administaff until March of this year -- offers an exceptionally strong balance sheet, with $10.35 in cash per share net of liabilities (including accrued workers' comp costs). Cash flow has been solid as well -- $46MM in the first six months of 2011, over 25% of enterprise value on an annualized basis. Given the inherent weakness in American employment, Insperity's profitability is impressive. The company also sports a dividend yield of 2.55%, which will increase put premiums.

For a short-term trade, the September 22.5 put is bid at 80 cents, offering 3.7% on risk capital (48% annualized). Our downside price here is $21.70, offering an 8% cushion. Farther out, aggressive traders can sell the January 22.5, bid at $2.00. This trade returns 9.75%, or 23% annualized. The most conservative trade is the January 17.5, bid at 50 cents. This returns 2.9% (7% annualized), with substantial downside protection: 28% on the underlying stock, and almost 50% on an enterprise basis.

  1. Kirkland's (NASDAQ:KIRK)

Closing Price 8/19: $8.82

Kirkland's is a retailer of home furnishings, furniture and gifts. The company reported earnings on Friday, swinging to a loss due to an 8% decrease in comparable sales and a "more aggressive than planned markdown cadence". The company's third quarter guidance -- expecting it to look much like the second quarter -- shouldn't have cheered investors, either.

But it did -- the stock jumped over 5% on a down day in the markets. It may have been the company's guidance for "significant cash flow"; the company forecast that cash reserves would grow $15-$25MM by year's end, despite accelerated spending on capital expenditures. The company's announced $40MM stock buyback program probably helped as well, given that the board authorization accounts for over 20% of the company's market capitalization.

Kirkland's offers $3.77 in cash per share, nearly 43% of the stock price. With an enterprise value right at $100MM, the company's expectation of cash flow over $10MM for the rest of the year offers a solid rate of return. Should the company meet even the bottom range of its cash flow projection, while executing a $40MM buyback, there should be significant downside protection to the stock.

Selling puts can offer more protection. The October 7.5 is bid at 25 cents (ask of 45 cents); with a 3.44% return on a 9-week trade, it offers a 20% annualized return, with successful limit orders offering higher upside. The January 7.5 is bid at 55 cents (last 65 cents) and offers more liquidity (open interest over 1700 contracts). It offers a 7.9% return (almost 19% annualized), with our downside price at $6.95 a share. That requires a 21% drop in the underlying Kirkland's stock in 22 weeks, and a fall of over 37% in the company's enterprise value.

  1. Lam Research (NASDAQ:LRCX)

Closing Price 8/19: $35.99

Lam has been hammered over the summer, along with the rest of the semiconductor industry, losing nearly 40% of its market value since March highs. Declining earnings are the cause, as the company is projected to make only $2.80/share in its next fiscal year (ending June 2012), less than half of the $5.79 it made in fiscal year 2011.

Despite the slowing earnings, the maker of semiconductor processing equipment offers value. Net cash is $11.11 per share, 31% of market cap. Trailing twelve-month free cash flow is $750MM, or 25% of enterprise value. Even amidst industry slowdowns Lam should still generate significant cash flow in 2012.

LRCX options are well-traded, offering a wealth of strike and expiration opportunities for investors. If interested in the underlying, investors should choose the risk/reward profile best suited for their portfolio. Below, here are four interesting ways to play Lam stock depending on risk tolerance and time horizon:

Short-Term Aggressive: Sell September 36 put, bid at $1.95 (last $2.00). Maximum return is 5.7% on a 4-week trade, or 74.4% annualized if the stock gains one penny before expiration. Downside price is $34.05.

Mid-Term Conservative: Sell December 30 put, bid at $1.55. Return is 5.4% on 17-week trade (16.6% annualized). Downside price is $28.45, requiring a 21% drop in the underlying stock (30% on an enterprise basis).

Long-Term Aggressive: Sell March 35 put, bid at $4.30. Return is 14% on a 30-week trade (24% annualized). Downside price is $30.70, nearly 15% off current levels.

Long-Term Conservative: Sell March 23 put, bid at 90 cents. Return is 4% (7% annualized). Downside price is $22.10, 38.5% off current levels (in 30 weeks), requiring an enterprise value fall of over 55%.

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