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In a prior article I explained why I thought it might be a good idea to sell Put options on Walter Energy, (NYSE:WLT).

In that piece, I described the actual trade that I put on; I sold 5 Put option contracts with a $40 strike price and an expiration of March 17, 2012, for a $5.00 premium. In this article I provide an update and commentary on that trade.

If you read my prior article, I said that I didn't think that WLT was a buy at $60 per share because of sketchy management and recurring operational issues. But I noted that plenty of potential suitors had looked at the Company and most likely continue to follow it. I felt that the possibility of a takeout attempt would attract investors into the stock if it remained at $60 per share or lower. For example, back on September 7th, WLT stock jumped to $91 per share upon speculation of a takeout offer from Anglo American (OTCPK:AAUKF).

By selling 5 $40 Put option contracts for a $5 premium, my break even price was $35, or 42% below the then current price of $60. The annualized return on the investment that I hoped to achieve was 25% if the stock were to close at $40 or above on March 17, 2012. I noted that 7 analysts who had updated or reiterated their price targets subsequent to WLT's huge earnings warning had an average price target of $101. Finally, I stressed that selling naked Put options is a risky strategy but that I was comforted by the margin of error embedded in the trade. The stock would have to fall by 42% for me to lose money. To be clear, let me flesh that out a bit more. The second I executed the option trade, I was paid a premium of $5 for selling an option to the buyer to "put" back to me shares of WLT at $40 per share anytime between the trade date and the expiration of the option on March 17, 2012.

What does that mean exactly? Each option contract represents 100 shares of stock. I sold 5 contracts, meaning that I sold the option for another investor to require me to buy from him 5 x 100 = 500 shares of WLT stock at a price of $40 per share anytime before expiry. I collected a premium of $5 per share, (not $5 per contract!) or $2,500 for, "writing" (selling) this option. I mentioned that my break even price was $35 per share. That's because I get to keep 100% of that $2,500 option premium no matter what happens. But, recall that on March 17, 2012, I have an obligation to buy 500 shares of WLT at $40 per share IF and only IF the option holder opts to sell me the shares. The option holder will only sell me 500 shares at $40 if the stock is trading below $40. By doing this, he can repurchase the shares he sold me at a lower price and pocket the difference.

Let's say that at the March 17, 2012, expiration day, WLT stock was trading at exactly $40 per share. In that event, the option holder would not bother to exercise his option because doing so would only enable him to sell me shares at the same price at which he could repurchase them. Therefore, I would have kept my entire option premium of $2,500 and the trade would be done. The same outcome applies if the stock closes at a price above $40 per share, i.e. I can't make a penny more than my premium no matter what happens. However, if the stock closed at $30 per share on the expiration date, then I would be obligated to pay (500 x $40 = $20,000) to acquire 500 shares of WLT stock that are only worth (500 x $300 = $15,000). My loss would be $20,000-$15,000 = $5,000. Actually, my loss would be less than that, it would be $5,000 minus the $2,500 premium that I collected on the trade date. So, in this scenario, I sold the Put option, got paid $2,500 on day 1 and held the $2,500 premium until the expiration date of March 17, 2012. At expiration, 500 shares were "put" back to me at an unfavorable price of $40 even though the share price closed that day at $30, and my all-in loss on the trade would be $2,500.

Effectively, if the stock were to fall by 50% by the expiration date, then my net loss at expiration would be $2,500. By comparison, if I had bought outright 500 shares at $60 (500 x $60 = $30,000) on same trade date, I would have lost $15,000. Now, these two transactions are not apples to apples because investors use options to articulate other aspects of a trade than just going long or short a stock. These other aspects include the use of leverage and a bet on the volatility of WLT stock and/or the volatility of the stock market. Another aspect of an options trade is that it may be executed as a hedge on the underlying stock.

And now to the main point of this article, an update on how my trade has performed. I sold 5 Put option contracts for a premium of = 500 shares for $5 per share = $2,500. Today, I can buy back the Put option contracts for $2.5 per share. Therefore, if I buy the 5 contracts that I sold, I would make a profit of $1,250 because I would be buying them back at 50% of what I sold them for. A profit of $1,250 in less than one month would be a very high annualized return. But, my reason for writing this article is not to calculate an annualized return, it's to demonstrate a very interesting aspect of the trade.

The option premium has fallen 50% from $5.00 per share to $2.50 per share, yet the underlying stock price has only moved by 7%. One of the two bets that I made on the trade date is paying off in spades. Recall, I was betting that volatility would decrease over time. This is happening as we speak. Could volatility spike again later today or next week or next month? Absolutely. But for now, selling options on a high volume stock is turning out to be a good trade. By no means does this suggest that the trade was not or is not a risky one. But it demonstrates a way to invest in a company in which one is very familiar, without having to bet entirely for or against it.

Source: Selling Puts On Walter Energy - Part II